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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended September 30, 2012

OR

For the transition period from           to           

Commission file number: 001-34620

IRONWOOD PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

(617) 621-7722

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:  Yes  x  No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files):  Yes  x  No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): o  Yes  x  No

As of October 29, 2012, there were 76,594,242 shares of Class A common stock outstanding and 30,911,113 shares of Class B common stock outstanding.

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NOTE REGARDING FORWARD-LOOKING STATEMENTS

This Quarterly Report on Form 10-Q, including the sections titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Risk Factors”, contains forward-looking statements. All statements contained in this Quarterly Report on Form 10-Q other than statements of historical fact are forward-looking statements. Forward-looking statements include statements regarding our future financial position, business strategy, budgets, projected costs, plans and objectives of management for future operations. The words “may,” “continue,” “estimate,” “intend,” “plan,” “will,” “believe,” “project,” “expect,” “seek,” “anticipate” and similar expressions may identify forward-looking statements, but the absence of these words does not necessarily mean that a statement is not forward-looking. These forward-looking statements include, among other things, statements about:

·                  the timing, investment and associated activities involved in commercializing LINZESS in the U.S.;

·                  our ability to manufacture sufficient amounts of LINZESS for commercial launch;

·                  our partners’ ability to obtain foreign regulatory approval of linaclotide and the ability of all of our product candidates to meet existing or future regulatory standards;

·                  our expectations regarding U.S. and foreign regulatory requirements, including our post-approval, non-clinical and clinical post-marketing plan with the FDA to understand linaclotide’s efficacy and safety in pediatric patients;

·                  the safety profile and related adverse events of linaclotide in adult patients;

·                  the ability of our partners to perform their obligations under our collaboration and license agreements with them;

·                  the therapeutic benefits and effectiveness of our product candidates;

·                  our plans with respect to collaborations and licenses related to the development, manufacture or sale of our product candidates, as well as the in-licensing or acquisition of externally discovered programs;

·                  our expectations as to future financial performance, expense levels, capital raising and liquidity sources;

·                  the ability to compete with other companies that are or may be developing or selling products that are competitive with our products and product candidates;

·                  the status of government regulation in the life sciences industry, particularly with respect to health care reform;

·                  anticipated trends and challenges in our potential markets; and

·                  our ability to attract and motivate key personnel.

Any or all of our forward-looking statements in this Quarterly Report on Form 10-Q may turn out to be inaccurate. These forward-looking statements may be affected by inaccurate assumptions or by known or unknown risks and uncertainties, including the risks, uncertainties and assumptions identified under the heading “Risk Factors” in this Quarterly Report on Form 10-Q. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur as contemplated, and actual results could differ materially from those anticipated or implied by the forward-looking statements.

You should not unduly rely on these forward-looking statements, which speak only as of the date of this Quarterly Report on Form 10-Q. Unless required by law, we undertake no obligation to publicly update or revise

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any forward-looking statements to reflect new information or future events or otherwise. You should, however, review the factors and risks we describe in the reports we will file from time to time with the SEC after the date of this Quarterly Report on Form 10-Q.

NOTE REGARDING TRADEMARKS

LINZESS™ and CONSTELLA® are trademarks of Ironwood Pharmaceuticals, Inc. Any other trademarks referred to in this Form 10-Q are the property of their respective owners. All rights reserved.

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IRONWOOD PHARMACEUTICALS, INC.

QUARTERLY REPORT ON FORM 10-Q

FOR THE QUARTER ENDED SEPTEMBER 30, 2012

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PART I – FINANCIAL INFORMATION

Item 1.  Financial Statements

Ironwood Pharmaceuticals, Inc.

Condensed Consolidated Balance Sheets

(In thousands, except share and per share amounts)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Ironwood Pharmaceuticals, Inc.

Condensed Consolidated Statements of Comprehensive Income (Loss)

(In thousands, except share and per share amounts)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Ironwood Pharmaceuticals, Inc.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(unaudited)

The accompanying notes are an integral part of these condensed consolidated financial statements.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

1. Nature of Business

Ironwood Pharmaceuticals, Inc. (the “Company”) is an entrepreneurial pharmaceutical company dedicated to the art and science of great drugmaking.  The Company’s lead product, linaclotide, will be marketed in the United States (“U.S.”) under the trademarked name of LINZESS. On August 30, 2012, the United States Food and Drug Administration (“FDA”) approved LINZESS as a once-daily treatment for adult men and women suffering from irritable bowel syndrome with constipation (“IBS-C”) or chronic idiopathic constipation (“CIC”). LINZESS is the first FDA-approved guanylate cyclase type-C (“GC-C”) agonist and it was shown in clinical trials to help relieve abdominal pain and constipation associated with IBS-C and improve constipation symptoms associated with CIC. LINZESS is being commercialized in the U.S. by the Company and its collaboration partner, Forest Laboratories, Inc. (“Forest”) and will become commercially available for the first time in December 2012.

In September 2011, the Company’s European partner, Almirall, S.A. (“Almirall”) submitted a Market Authorization Application (“MAA”) to the European Medicines Agency (“EMA”) for linaclotide for the treatment of patients with IBS-C, and Almirall continues to work with the EMA in its review. On September 21, 2012, the EMA’s European Committee for Medicinal Products for Human Use, which provides non-binding recommendations for consideration by the EMA, issued a positive opinion recommending the marketing approval for linaclotide for the treatment of moderate to severe IBS-C in adults.

Astellas Pharma Inc. (“Astellas”), the Company’s partner for Japan and certain other Asian countries, continues to develop linaclotide for the treatment of patients with IBS-C in its territory.

The Company continues to assess alternatives to bring linaclotide to IBS-C and CIC sufferers in the parts of the world outside of its partnered territories. In May 2012, the Company submitted a Clinical Trial Application (“CTA”) to China’s State Food and Drug Administration for a Phase 3 trial of linaclotide in patients with IBS-C. The CTA has been accepted for review. In October 2012, the Company also entered into a collaboration agreement with AstraZeneca AB (“AstraZeneca”) to co-develop and co-commercialize linaclotide in China (Note 13).

The Company continues to assess opportunities to expand the utility of linaclotide as well as the patient population who could benefit from linaclotide to ensure that it is maximizing the drug’s potential value. As part of its long-term strategy, the Company and Forest initiated a Phase 3b clinical trial to further characterize the effect of linaclotide on abdominal symptoms in patients with CIC. In addition, the Company continues to explore the potential for linaclotide in other patient populations as well as in other gastrointestinal indications.

The Company also has a pipeline focused on early development candidates and discovery research in multiple therapeutic areas, including gastrointestinal disease, central nervous system (“CNS”) disorders, respiratory disease and cardiovascular disease.

The Company was incorporated in Delaware on January 5, 1998. On April 7, 2008, the Company changed its name from Microbia, Inc. to Ironwood Pharmaceuticals, Inc. The Company currently operates in one reportable business segment—human therapeutics.

The Company has generated an accumulated deficit as of September 30, 2012 of approximately $461.2 million since inception. In February 2010, the Company completed its initial public offering of Class A common stock and raised a total of approximately $203.2 million in net proceeds. Additionally, in February 2012, the Company sold 6,037,500 shares of its Class A common stock through a follow-on public offering and raised a total of approximately $85.2 million in net proceeds (Note 10).

2. Summary of Significant Accounting Policies

Unaudited Interim Financial Statements

The accompanying condensed consolidated financial statements and the related disclosures as of September 30, 2012 and for the three and nine months ended September 30, 2012 and 2011 are unaudited and have been prepared in accordance with accounting principles generally accepted in the U.S. (“GAAP”) and the applicable rules and regulations of the Securities and Exchange Commission (‘‘SEC’’) for interim financial information. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements.  These interim condensed consolidated financial statements should be read in conjunction

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

with the consolidated financial statements and notes thereto contained in the Company’s Annual Report on Form 10-K filed with the SEC on February 29, 2012. The December 31, 2011 condensed consolidated balance sheet included herein was derived from the audited financial statements as of that date, but does not include all disclosures including notes required by GAAP for complete financial statements.

The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements and, in the opinion of management, reflect all adjustments of a normal recurring nature considered necessary to present fairly the Company’s financial position as of September 30, 2012, results of its operations for the three and nine months ended September 30, 2012 and 2011 and its cash flows for the nine months ended September 30, 2012 and 2011. The interim results for the three and nine months ended September 30, 2012 are not necessarily indicative of the results that may be expected for the year ending December 31, 2012.

Principles of Consolidation

The accompanying condensed consolidated financial statements include the accounts of Ironwood Pharmaceuticals, Inc. and its wholly owned subsidiaries, Ironwood Pharmaceuticals Securities Corporation and Ironwood Pharmaceuticals GmbH. All intercompany transactions and balances are eliminated in consolidation.

Use of Estimates

The preparation of consolidated financial statements in accordance with GAAP requires the Company’s management to make estimates and judgments that may affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, the Company’s management evaluates its estimates, including those related to revenue recognition, available-for-sale securities, inventory valuation and related reserves, impairment of long-lived assets, income taxes including the valuation allowance for deferred tax assets, research and development expense, contingencies and share-based compensation. The Company bases its estimates on historical experience and on various other assumptions that are believed to be reasonable, the results of which form the basis for making judgments about the carrying values of assets and liabilities. Actual results may differ from these estimates under different assumptions or conditions. Changes in estimates are reflected in reported results in the period in which they become known.

Cash and Cash Equivalents

The Company considers all highly liquid investment instruments with a remaining maturity when purchased of three months or less to be cash equivalents. Investments qualifying as cash equivalents primarily consist of money market funds. The carrying amount of cash equivalents approximates fair value. The amount of cash equivalents included in cash and cash equivalents was approximately $33.0 million and $77.2 million at September 30, 2012 and December 31, 2011, respectively.

Available-for-Sale Securities

The Company classifies all short-term investments with a remaining maturity when purchased of greater than three months as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported in other comprehensive income (loss). The amortized cost of debt securities in this category is adjusted for the amortization of premiums and accretion of discounts to maturity. Such amortization is included in interest and investment income. Realized gains and losses, interest, dividends, and declines in value judged to be other than temporary on available-for-sale securities are included in interest and investment income.

The cost of securities sold is based on the specific identification method. To determine whether an other-than-temporary impairment exists, the Company considers whether it has the ability and intent to hold the investment until a market price recovery, and whether evidence indicating the recoverability of the cost of the investment outweighs evidence to the contrary. There were no other-than-temporary impairments for the three and nine months ended September 30, 2012 and 2011.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Inventory

Inventory is stated at the lower of cost or market with cost determined under the first-in, first-out basis.

The Company evaluates inventory levels quarterly and any inventory that has a cost basis in excess of its expected net realizable value, inventory that becomes obsolete, inventory in excess of expected sales requirements or inventory that fails to meet commercial sale specifications is written down with a corresponding charge to cost of revenues in the period that the impairment is first identified.

The Company capitalizes inventories manufactured in preparation for initiating sales of a product candidate when the related product candidate is considered to have a high likelihood of regulatory approval and the related costs are expected to be recoverable through sales of the inventories. In determining whether or not to capitalize such inventories, the Company evaluates, among other factors, information regarding the product candidate’s safety and efficacy, the status of regulatory submissions and communications with regulatory authorities and the outlook for commercial sales, including the existence of current or anticipated competitive drugs and the availability of reimbursement. In addition, the Company evaluates risks associated with manufacturing the product candidate and the remaining shelf life of the inventories.

Costs associated with developmental products prior to satisfying the inventory capitalization criteria are charged to research and development expense as incurred.

Concentrations of Suppliers

The Company relies on third-party manufacturers and its collaboration partners to manufacture the linaclotide active pharmaceutical ingredient (“API”) and final linaclotide drug product. Currently, there are two third-party manufacturers approved for the production of the linaclotide API in three facilities. The Company’s collaboration partners, except AstraZeneca in China, (Forest, Almirall and Astellas) are responsible for drug product manufacturing of linaclotide into finished product for their respective territories. The Company also has an agreement with another independent third party to provide drug product manufacturing of linaclotide for its unpartnered territories and to potentially provide a second source of drug product manufacturing of linaclotide for its partnered territories. The Company and AstraZeneca also continue to explore manufacturing alternatives for China. If any of the Company’s suppliers were to limit or terminate production or otherwise fail to meet the quality or delivery requirements needed to satisfy the supply commitments, the process of locating and qualifying alternate sources could require up to several months, during which time the Company’s production could be delayed.  Such delays could have a material adverse effect on the Company’s business, financial position and results of operations.

Concentrations of Credit Risk

Financial instruments that subject the Company to credit risk primarily consist of cash and cash equivalents, restricted cash, available-for-sale securities and accounts receivable. The Company maintains its cash and cash equivalent balances with high-quality financial institutions and, consequently, the Company believes that such funds are subject to minimal credit risk. The Company’s available-for-sale investments primarily consist of U.S. Treasury securities and certain U.S. government sponsored securities and potentially subject the Company to concentrations of credit risk. The Company has adopted an investment policy which limits the amounts the Company may invest in any one type of investment, and requires all investments held by the Company to be at least A+ rated, thereby reducing credit risk concentration.

Accounts receivable, including related party accounts receivable, primarily consist of amounts due under the collaboration agreement with Forest and license agreements with Almirall and Astellas (Note 4) for which the Company does not obtain collateral. Accounts receivable or payable, to or from Forest and Almirall are presented as related party transactions on the condensed consolidated balance sheets as both entities own common stock of the Company.

The Company’s significant customers are summarized in the table below.  The percentages of revenue recognized during the three and nine months ended September 30, 2012 and 2011 are shown, as well as the accounts receivable balance, net of any payables due, at September 30, 2012 and December 31, 2011.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

For the three and nine months ended September 30, 2012 and 2011, no additional customers accounted for more than 10% of the Company’s revenue.

Revenue Recognition

The Company’s revenue is generated through collaborative research and development and licensing agreements. The terms of these agreements contain multiple deliverables which may include (i) licenses, (ii) research and development activities, including participation on a joint development committee, and (iii) the manufacture of API and development materials for the collaborative partner which are reimbursed at a contractually determined rate. To date, the Company’s collaborative research and development and licensing agreements have included only the license to develop and commercialize linaclotide, the Company’s first GC-C agonist. Non-refundable payments to the Company under these agreements may include (i) up-front license fees, (ii) payments for research and development activities, (iii) payments for the manufacture of API and development materials, (iv) payments based upon the achievement of certain milestones, and (v) royalties on product sales. Additionally, the Company will receive 50% of the net profits or bear 50% of the net losses from the sale of LINZESS in the U.S, expected to begin in December 2012.

There are no performance, cancellation, termination or refund provisions in any of the Company’s arrangements that contain material financial consequences to the Company.

At September 30, 2012, the Company had collaboration and license agreements with Forest, Almirall and Astellas. Refer to Note 4, “Collaboration and License Agreements,” for additional discussion of these agreements. In October 2012, the Company also entered into a collaboration agreement with AstraZeneca to co-develop and co-commercialize linaclotide in China (Note 13).

Agreements Entered into Prior to January 1, 2011

For arrangements that include multiple deliverables, the Company follows the provisions of the Accounting Standards Codification (“ASC”) Topic 605-25, Revenue Recognition—Multiple-Element Arrangements (“ASC 605-25”), in accounting for these agreements. Under ASC 605-25, the Company is required to identify the deliverables included within the agreement and evaluate which deliverables represent separate units of accounting. Collaborative research and development and licensing agreements that contain multiple deliverables are divided into separate units of accounting if certain criteria are met, as follows:

·                  Delivered element(s) has value to the collaborator on a standalone basis,

·                  There is objective and reliable evidence of the fair value of the undelivered obligation(s), and

·                  If the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially within the Company’s control.

The Company allocates arrangement consideration among the separate units of accounting either on the basis of each unit’s respective fair value or using the residual method, and applies the applicable revenue recognition criteria to each of the separate units. If the separation criteria are not met, revenue of the combined unit of accounting is recorded based on the method appropriate for the last delivered item. The Company recognizes revenue when there is persuasive evidence that an arrangement exists, services have been rendered or delivery has occurred, the price is fixed or determinable, and collection is reasonably assured.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Up-Front License Fees

The Company recognizes revenue from nonrefundable, up-front license fees on a straight-line basis over the contracted or estimated period of performance, which is typically the period over which the research and development is expected to occur or manufacturing services are expected to be provided. Accordingly, the Company is required to make estimates regarding the drug development and commercialization timelines for drugs and drug candidates being developed pursuant to the applicable agreement. The determination of the length of the period over which to recognize the revenue is subject to judgment and estimation and can have an impact on the amount of revenue recognized in a given period. Quarterly, the Company reassesses its period of substantial involvement over which the Company amortizes its up-front license fees and makes adjustments as appropriate. During the three and nine months ended September 30, 2012, the Company’s estimates regarding the period of performance under its collaborative research and development and licensing agreements did not change; however, they have changed in the past and may change in the future. In the event that a license were to be terminated, the Company would recognize as revenue any portion of the up-front fee that had not previously been recorded as revenue, but was classified as deferred revenue at the date of such termination.

Up-front payments on a license are deferred if the relevant facts and circumstances dictate that the license does not have standalone value to the partner. Factors considered in this determination include the research capabilities of the partner and the availability of peptide research expertise in the general marketplace. In addition, the Company considers whether the collaborator can use the license for its intended purpose without the receipt of the remaining deliverables, and whether the value of the license is dependent on the undelivered items and whether there are other vendors that can provide the undelivered item.

Milestones

At the inception of each arrangement that includes milestone payments, the Company evaluates whether each milestone is substantive and at risk to both parties on the basis of the contingent nature of the milestone. This evaluation includes an assessment of whether (a) the consideration is commensurate with either (1) the entity’s performance to achieve the milestone, or (2) the enhancement of the value of the delivered item(s) as a result of a specific outcome resulting from the entity’s performance to achieve the milestone, (b) the consideration relates solely to past performance, and (c) the consideration is reasonable relative to all of the deliverables and payment terms within the arrangement. The Company evaluates factors such as the scientific, clinical, regulatory, commercial and other risks that must be overcome to achieve the respective milestone, the level of effort and investment required and whether the milestone consideration is reasonable relative to all deliverables and payment terms in the arrangement in making this assessment.

Prior to January 1, 2011, in those circumstances where a substantive milestone was achieved, collection of the related receivable is reasonably assured and the Company had remaining obligations to perform under the collaboration arrangement, the Company recognized as revenue on the date the milestone was achieved an amount equal to the applicable percentage of the performance period that had elapsed as of the date the milestone was achieved, with the balance being deferred and recognized on a straight-line basis over the remaining period of performance. Effective January 1, 2011, the Company adopted Accounting Standards Update (“ASU”) No. 2010-17, Revenue Recognition—Milestone Method (“ASU 2010-17”) on a prospective basis. Under ASU 2010-17, in those circumstances where a substantive milestone is achieved and collection of the related receivable is reasonably assured, the Company recognizes revenue related to the milestone in its entirety in the period in which the milestone is achieved. Milestone payments received prior to the adoption of ASU 2010-17 have continued to be recognized over the remaining period of performance. Milestones that are not considered substantive are recognized on a straight-line basis over the remaining period of performance.

Other

The Company produces development materials and API for certain of its collaborators.  The Company recognizes revenue on development material and API when the material has passed all quality testing required for collaborator acceptance, delivery has occurred, title and risk of loss have transferred to the collaborator, the price is fixed or determinable, and collection is reasonably assured. As it related to development materials and API produced for Almirall and Astellas, the Company is reimbursed at a contracted rate. Such reimbursements are considered as part of revenue generated by Almirall and Astellas license agreements and presented as collaborative arrangements revenue. Any development materials and API currently produced for Forest are recognized in accordance with the cost-sharing provisions of the Forest collaboration agreement.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The Company receives cost-sharing payments for research and development and general and administrative expenses under the Forest collaboration agreement and considers the nature and contractual terms of the arrangement and the nature of the Company’s business operations to determine whether the payments will result in collaborative revenues or an offset to research and development or general and administrative expenses. Additionally, the Company considers the factors or indicators within this arrangement to determine whether reporting transactions under the Company’s collaboration agreements on a gross or net basis is appropriate. The Company records revenue transactions gross in the condensed consolidated statements of comprehensive income (loss) if it is deemed the principal in the transaction, which includes being the primary obligor and having the risks and rewards of ownership.

For certain of the Company’s arrangements, particularly the license agreement with Almirall, it is required that taxes be withheld on its payments. The Company has adopted a policy to recognize revenue net of these tax withholdings.

Agreements Entered into or Materially Modified on or after January 1, 2011

Effective January 1, 2011, the Company adopted ASU No. 2009-13, Multiple-Deliverable Revenue Arrangements (“ASU 2009-13”), on a prospective basis. ASU 2009-13 amends ASC 605-25 to provide updated revenue recognition guidance on whether multiple deliverables in an arrangement exist, how multiple deliverables in an arrangement should be separated and how the arrangement consideration should be allocated. More specifically, the revised guidance eliminates the requirement to establish vendor-specific objective evidence of fair value or third-party evidence of fair value of undelivered elements in order to separate a deliverable. Additionally, ASU 2009-13 eliminates the use of the residual method by requiring revenues to be allocated using the relative selling price method. Under the relative selling price method, arrangement consideration is allocated to each separate unit of accounting based on the relative selling price of each deliverable. The estimated selling price of each deliverable is determined using the following hierarchy of values (i) vendor-specific objective evidence of selling price, (ii) third-party evidence of selling price, and (iii) best estimate of the selling price (“BESP”). The BESP reflects the Company’s best estimate of what the selling price would be if the deliverable was regularly sold on a standalone basis. Through September 30, 2012, the Company did not enter into any material agreements or material modifications to existing agreements that would be accounted for pursuant to this updated guidance. However, in October 2012, the Company entered into a collaboration agreement with AstraZeneca to co-develop and co-commercialize linaclotide in China (Note 13). This new agreement will be accounted for in accordance with ASU 2009-13.

Research and Development Costs

The Company expenses research and development costs to operations as incurred. The Company defers and capitalizes nonrefundable advance payments made by the Company for research and development activities until the related goods are received or the related services are performed.

Research and development expenses are comprised of costs incurred in performing research and development activities, including salary and benefits; share-based compensation expense; laboratory supplies and other direct expenses; facilities expenses; overhead expenses; contractual services, including clinical trial and related clinical manufacturing expenses, including supply chain development; and other outside expenses.

The Company has entered into a collaboration agreement with Forest in which it shares research and development expenses. The Company records the expenses for such work as research and development expense. Because the collaboration arrangement is a cost-sharing arrangement, the Company concluded that when there is a period during the collaboration arrangement during which the Company receives payments from Forest, the Company records the payments by Forest for their share of the development effort as a reduction of research and development expense.

Share-Based Compensation

The Company’s stock-based compensation programs grant awards which have included stock awards, restricted stock, and stock options. Share-based compensation is recognized as an expense in the financial statements based on the grant date fair value. For awards that vest based on service conditions, the Company uses the straight-line method to allocate compensation expense to reporting periods. The grant date fair value of options granted is calculated using the Black-Scholes option-pricing model, which requires the use of subjective assumptions including volatility, expected term and the fair value of the underlying common stock, among others.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The Company records the expense for stock option grants subject to performance-based milestone vesting using the accelerated attribution method over the remaining service period when management determines that achievement of the milestone is probable. Management evaluates when the achievement of a performance-based milestone is probable based on the relative satisfaction of the performance conditions as of the reporting date.

The Company records the expense of services rendered by non-employees based on the estimated fair value of the stock option using the Black-Scholes option-pricing model. The fair value of unvested non-employee awards are remeasured at each reporting period and expensed over the vesting term of the underlying stock options.

Net Income (Loss) Per Share

The Company calculates basic net income (loss) per common share and diluted net loss per common share by dividing the net income (loss) by the weighted average number of common shares outstanding during the period. Diluted net income per common share is computed by dividing net income by the diluted number of shares outstanding during the period. Except where the result would be antidilutive to net income, diluted net income per share is computed assuming the exercise of common stock options and the vesting of restricted stock (using the treasury stock method), as well as their related income tax effects. The Company allocates undistributed earnings between the classes on a one-to-one basis when computing net income (loss) per share.  As a result, basic and diluted net income (loss) per Class A and Class B shares are equivalent.

Income Taxes

The Company provides for income taxes under the liability method. Deferred tax assets and liabilities are determined based on differences between financial reporting and tax bases of assets and liabilities and are measured using the enacted tax rates in effect when the differences are expected to reverse. Deferred tax assets are reduced by a valuation allowance to reflect the uncertainty associated with their ultimate realization.

Management of the Company has evaluated the positive and negative evidence bearing upon the realizability of its deferred tax assets. Management has considered the Company’s history of operating losses and concluded, in accordance with the applicable accounting standards, that it is more likely than not that the Company will not realize the benefit of its deferred tax assets. Accordingly, the deferred tax assets have been fully reserved at September 30, 2012 and December 31, 2011. Management reevaluates the positive and negative evidence on a quarterly basis.

The Company accounts for uncertain tax positions recognized in the condensed consolidated financial statements by prescribing a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return.

Impairment of Long-Lived Assets

The Company regularly reviews the carrying amount of its long-lived assets to determine whether indicators of impairment may exist, which warrant adjustments to carrying values or estimated useful lives. If indications of impairment exist, projected future undiscounted cash flows associated with the asset are compared to the carrying amount to determine whether the asset’s value is recoverable. If the carrying value of the asset exceeds such projected undiscounted cash flows, the asset will be written down to its estimated fair value. There were no indicators of impairment at September 30, 2012 or December 31, 2011.

Segment Information

Operating segments are components of an enterprise for which separate financial information is available and is evaluated regularly by the Company’s chief operating decision-maker in deciding how to allocate resources and in assessing performance. The Company currently operates in one reportable business segment—human therapeutics.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

New Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the Financial Accounting Standards Board (“FASB”) or other standard setting bodies that are adopted by the Company as of the specified effective date. Unless otherwise discussed, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its consolidated financial position or results of operations upon adoption.

Recently Adopted Accounting Standards

In May 2011, the FASB issued ASU No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs (“ASU 2011-04”). ASU 2011-04 amends ASC 820, Fair Value Measurement, to ensure that fair value has the same meaning in GAAP and International Financial Reporting Standards (“IFRS”) and improves the comparability of the fair value measurement and disclosure requirements in GAAP and IFRS. ASU 2011-04 applies to all entities that measure assets, liabilities or instruments classified in shareholder’s equity at fair value, or provide fair value disclosures for items not recorded at fair value. ASU 2011-04 results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRS. Consequently, ASU 2011-04 changes the wording used to describe many of the requirements in U.S. GAAP for measuring fair value and for disclosing information about fair value measurements. For many of the requirements, ASU 2011-04 will not result in a change in the application of the requirements in ASC 820. Some of the requirements in ASU 2011-04 clarify the FASB’s intent about the application of existing fair value measurement requirements. Other requirements change a particular principle or requirement for measuring fair value or for disclosing information about fair value measurements. ASU 2011-04 is effective for public companies for interim and annual periods beginning after December 15, 2011 and should be applied prospectively. Early application is not permitted. On January 1, 2012, the Company adopted ASU 2011-04 on a prospective basis. The adoption did not have a material impact on the Company’s consolidated financial position or results of operations.

In June 2011, the FASB issued ASU No. 2011-05, Presentation of Comprehensive Income (“ASU 2011-05”) which is intended to facilitate the convergence of U.S. GAAP and IFRS as well as to increase the transparency of items reported in other comprehensive income. As a result of ASU 2011-05, all nonowner changes in stockholders’ equity are required to be presented in a single continuous statement of comprehensive income or in two separate but consecutive statements. The option to present other comprehensive income in the statement of changes in equity has been eliminated. ASU 2011-05 is effective for public companies for fiscal years, and interim periods within those years, beginning after December 15, 2011 and should be applied retrospectively. In December 2011, the FASB issued ASU No. 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05 (“ASU 2011-12”) which defers the effective date of the provisions of ASU 2011-05 pertaining to the presentation of reclassification adjustments out of accumulated other comprehensive income. All other requirements in ASU 2011-05 are not affected by ASU 2011-12. ASU 2011-12 is effective for public companies for fiscal years, and interim periods within those years, beginning after December 15, 2011. On January 1, 2012, the Company adopted ASU 2011-05 and ASU 2011-12 on a retrospective basis. The Company has elected to present all nonowner changes in stockholders’ equity in a single continuous statement of comprehensive income (loss). The adoption did not have a material impact on the Company’s consolidated financial position or results of operations since these standards impact presentation only.

3. Net Loss Per Share

The following table sets forth the computation of basic and diluted net income (loss) per share (in thousands, except per share amounts):

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The following potentially dilutive securities have been excluded from the computation of diluted weighted average shares outstanding as they would be anti-dilutive:

The number of shares issuable under the Company’s employee stock purchase plan that were excluded from the calculation of diluted net income (loss) per share because their effects were anti-dilutive was insignificant.

4. Collaboration and License Agreements

Forest Laboratories, Inc.

In September 2007, the Company entered into a collaboration agreement with Forest to jointly develop and commercialize linaclotide for the treatment of IBS-C, CIC and other gastrointestinal conditions in North America. Under the terms of this collaboration agreement, the Company shares equally with Forest all development costs as well as future net profits or losses from the development and sale of linaclotide in the U.S. The Company will also receive royalties in the mid-teens based on net sales in Canada and Mexico. Forest is solely responsible for the further development, regulatory approval and commercialization of linaclotide in those countries and funding any costs. The Company retained the rights to develop and commercialize linaclotide outside of North America. Forest made non-refundable, up-front payments totaling $70.0 million to the Company in order to obtain rights to linaclotide in North America. Because the license to jointly develop and commercialize linaclotide did not have a standalone value without research and development activities provided by the Company, the Company recorded the up-front license fee as collaboration revenue on a straight-line basis through September 30, 2012, the period over which linaclotide was jointly developed under the collaboration. The collaboration agreement also includes contingent milestone payments, as well as a contingent equity investment, based on the achievement of specific development and commercial milestones. These payments, including the up-front license fee, could total up to $330.0 million if certain development and sales milestones are achieved for linaclotide. At September 30, 2012, $205.0 million in license fees and development milestone payments had been received by the Company, as well as a $25.0 million equity investment in the Company’s capital stock. The Company can also achieve up to approximately $100.0 million in a sales related milestone if certain conditions are met.

The collaboration agreement included a contingent equity investment, in the form of a forward purchase contract, which required Forest to purchase shares of the Company’s convertible preferred stock upon achievement of a specific clinical milestone. Based on the Company’s evaluation, this financial instrument was considered an asset or liability, which was required to be carried at fair value. At the inception of the arrangement, the Company valued the contingent equity investment and recorded a $9.0 million asset and incremental deferred revenue. The $9.0 million of incremental deferred revenue was recognized as revenue on a straight-line basis over the period of the Company’s continuing involvement. At September 30, 2012, the incremental deferred revenue was fully amortized. In July 2009, the Company achieved the clinical milestone triggering the equity investment and reclassified the forward purchase contract as a reduction to convertible preferred stock. The Company issued the 2,083,333 shares to Forest on September 1, 2009.

The Company has achieved all six of the development milestones under this agreement. In September 2008 and July 2009, the Company achieved development milestones which triggered $10.0 million and $20 million milestone payments, respectively.  These development milestones were recognized as revenue on a straight-line basis over the period of the Company’s continuing involvement, which ended in September 2012.  In October 2011, the Company achieved two development milestones upon the FDA’s

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

acceptance of the linaclotide NDA for both IBS-C and CIC and received milestone payments of $20.0 million from Forest. In August 2012, the Company achieved additional two development milestones upon the FDA’s approval of the linaclotide NDA for both IBS-C and CIC and in September 2012 received milestone payments of $85.0 million from Forest. In accordance with ASU 2010-17, adopted in January 2011, the last four development milestones were recognized as revenue in their entirety upon achievement.

The Company recognized revenue from the Forest collaboration agreement totaling approximately $89.5 million and $100.4 million during the three and nine months ended September 30, 2012, respectively and approximately $5.4 million and $16.4 million during the three and nine months ended September 30, 2011, respectively.

Further, because the Company shares development costs equally with Forest, payments from Forest with respect to both research and development and general and administrative costs incurred by the Company are recorded as a reduction to expense, and not as revenue. As a result of the cost-sharing arrangements under the collaboration, the Company recognized approximately $0.4 million and $0.8 million in incremental research and development costs during the three and nine months ended September 30, 2012, respectively, and approximately $2.5 million and $7.5 million in incremental general and administrative expense, respectively. During the three and nine months ended September 30, 2011, as a result of the cost-sharing arrangements under the collaboration, the Company offset approximately $0.5 million and $6.7 million, respectively, against research and development expense. During the three months ended September 30, 2011, the Company recognized approximately $0.2 million in incremental general and administrative expense and during the nine months ended September 30, 2011, the Company recorded approximately $0.5 million as a reduction to general and administrative expense related to the cost-sharing arrangement.

Upon commercialization in the fourth quarter of 2012, the Company will receive 50% of the net profits or bear 50% of the net losses from the sale of LINZESS in the U.S., provided, however, that if either party provides fewer details in a particular year than it is contractually required to provide, such party’s share of the net profits will be reduced as stipulated by the collaboration agreement. Net profits or net losses consist of net sales to third-party customers and sublicense income in the U.S. less the cost to manufacture LINZESS as well as distribution, selling, and marketing expenses. Net sales are calculated by Forest and include gross sales net of discounts, allowances, sales taxes, freight and insurance charges, and other applicable deductions.

Almirall, S.A.

In April 2009, the Company entered into a license agreement with Almirall for European rights to develop and commercialize linaclotide for the treatment of IBS-C, CIC and other gastrointestinal conditions. Under the terms of the license agreement, Almirall is responsible for the expenses associated with the development and commercialization of linaclotide in the European territory. The license agreement requires the Company to participate on a joint development committee over linaclotide’s development period. The Company will receive escalating royalties from the sales of linaclotide in the European territory. In May 2009, the Company received a $38.0 million payment from Almirall representing a $40.0 million non-refundable up-front payment net of foreign withholding taxes. The Company elected to record the non-refundable up-front payment net of taxes withheld. The Company is recognizing the up-front license fee as revenue on a straight-line basis over the Company’s estimate of the period over which linaclotide will be developed under the license agreement for the European territory. In June 2011, the Company revised its estimate of the development period from 50 months to 41 months and based on the Company’s assessment of approval timelines adjusted its amortization of the remaining deferred revenue, accordingly. This resulted in the recognition of an additional approximately $2.8 million of revenue in the nine months ended September 30, 2011. At September 30, 2012, the up-front license fee was fully amortized. The license agreement also includes contingent milestone payments, as well as a contingent equity investment, that could total up to $55.0 million upon achievement of specific clinical and sales milestones. At September 30, 2012, $19.0 million, net of foreign withholding taxes, in development milestone payments has already been received, as well as a $15.0 million equity investment in the Company’s capital stock. Remaining milestone payments, each of which the Company considers substantive, consist of $4.0 million due upon the first commercial launch in each of the five major E.U. countries set forth in the agreement.

The license agreement included a contingent equity investment, in the form of a forward purchase contract, which required Almirall to purchase shares of the Company’s convertible preferred stock upon achievement of a specific clinical milestone. Based on the Company’s evaluation, this financial instrument was considered an asset or liability, which was required to be carried at fair value. The contingent equity investment was valued at inception at its fair value. At the inception of the arrangement, the Company valued the contingent equity investment and recorded a $6.0 million asset and incremental deferred revenue. The $6.0 million of incremental deferred revenue was recognized as revenue on a straight-line basis through September 2012. In November 2009, the Company

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

achieved the clinical milestone triggering the equity investment and reclassified the forward purchase contract as a reduction to convertible preferred stock. On November 13, 2009, the Company received $15.0 million from Almirall for the purchase of 681,819 shares of convertible preferred stock.

In November 2010, the Company achieved a development milestone under the Almirall license agreement, which resulted in a $19.0 million payment, representing a $20.0 million milestone, net of foreign withholding taxes. The Company recognized revenue of approximately $7.2 million upon achievement of the milestone. This amount represented the portion of the milestone payment equal to the applicable percentage of the performance period that had elapsed as of the date the milestone was achieved. The remainder of the balance was deferred and was recognized on a straight-line basis through September 2012.

The Company recognized approximately $5.9 million and $20.2 million in total revenue from the Almirall license agreement during the three and nine months ended September 30, 2012, respectively, including approximately $13,000 and $2.5 million, respectively, from the sale of API to Almirall. The Company recognized approximately $5.9 million and $14.6 million in total revenue from the Almirall license agreement during the three and nine months ended September 30, 2011, respectively, including approximately $0.5 million during the nine months ended September 30, 2011 from the sale of API to Almirall.

Astellas Pharma Inc.

In November 2009, the Company entered into a license agreement with Astellas. Astellas has the right to develop and commercialize linaclotide for the treatment of IBS-C, CIC and other gastrointestinal conditions in Japan, South Korea, Taiwan, Thailand, the Philippines and Indonesia. Under the terms of the agreement, Astellas paid the Company an up-front licensing fee of $30.0 million. The license agreement requires the Company to participate on a joint development committee over linaclotide’s development period. The agreement includes additional development milestone payments, each of which the Company considers substantive, that could total up to $45.0 million. These milestone payments consist of $15.0 million upon initiation of a Phase 3 study for linaclotide in Japan, $15.0 million upon filing of the Japanese equivalent of an NDA with the relevant regulatory authority in Japan, and $15.0 million upon approval of such equivalent by the relevant regulatory authority. In addition, the Company will receive escalating royalties on linaclotide sales should Astellas receive approval to market and sell linaclotide in the Asian market. Astellas will be responsible for activities relating to regulatory approval and commercialization. The Company is recognizing the up-front license fee as revenue on a straight-line basis over 115 months, which is the Company’s estimate of the period over which linaclotide will be developed under the license agreement for the Asian market. At September 30, 2012, approximately $21.9 million of the up-front license fee remains deferred. During the three and nine months ended September 30, 2012, the Company recognized approximately $1.0 million and $2.7 million respectively, in revenue from the Astellas license agreement, including approximately $0.2 million and $0.3 million, respectively, from the sale of API to Astellas. During the three and nine months ended September 30, 2011, the Company recognized approximately $0.9 million and $2.7 million, respectively, in revenue from the Astellas license agreement, including approximately $0.1 million and $0.4 million, respectively from the sale of API to Astellas.

Protagonist Therapeutics, Inc.

The Company entered into a collaboration agreement with Protagonist Therapeutics, Inc. and Protagonist Pty Ltd. (collectively “Protagonist”) in January 2011. Under this agreement, Protagonist will use its proprietary technology platform to discover peptides against certain targets and the Company has the rights to develop and commercialize these peptides. In connection with entering into the agreement, the Company made an up-front payment to Protagonist of approximately $2.8 million. In accordance with the applicable accounting guidance, the Company expensed the up-front payment as research and development expense. The Company also funds full-time equivalents for Protagonist’s drug discovery activities, and will make certain milestone and royalty payments for each product pending the achievement of certain development and commercialization milestones. These contingent milestones could total up to approximately $111.5 million per product if all milestones are achieved. The Company will expense these payments as incurred. During the three and nine months ended September 30, 2012, the Company recorded approximately $0.7 million and $2.0 million, respectively, in research and development expense associated with the Protagonist agreement. During the three and nine months ended September 30, 2011, the Company recorded approximately $0.6 million and $4.4 million, respectively, in research and development expense, including the up-front payment, associated with the Protagonist agreement.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

Bionomics Limited

On January 4, 2012, the Company entered into a collaboration, research and license agreement with Bionomics Limited (“Bionomics”) in which it licensed the rights to Bionomics’ investigational anti-anxiety compound, BNC210, which Ironwood designates as IW-2143. Under the terms of the agreement, the Company and Bionomics will collaborate on initial research and the Company will be responsible for worldwide development and commercialization of any resulting products, including funding of clinical trials. In connection with entering into the agreement, the Company made an up-front payment to Bionomics of $3.0 million. In accordance with the applicable accounting guidance, the Company expensed the up-front payment as research and development expense. The Company also funds full-time equivalents for Bionomics to perform certain drug discovery activities, will make certain milestone payments pending the achievement of certain development and regulatory milestones, and will make royalty payments if IW-2143 is ever successfully commercialized. Pending achievement of certain development and regulatory milestones, Bionomics could receive up to $345.0 million in up-front and milestone payments and research funding, as well as royalties on sales of products incorporating IW-2143 and other related compounds. The Company will expense these payments as incurred. During the three and nine months ended September 30, 2012, the Company recorded approximately $0.4 million and $4.1 million, respectively, in research and development expense, including the up-front payment, associated with the Bionomics agreement.

Other

The Company has other collaborations that are not individually significant to its business. Pursuant to the terms of those agreements, the Company may be required to pay additional amounts upon the achievement of various development, regulatory and commercial milestones which in the aggregate could be significant. The Company may also incur significant research and development costs if the related product candidate were to advance to late stage clinical trials. In addition, if any products related to these collaborations are approved for sale, the Company may be required to pay significant royalties on future sales. The payment of these amounts, however, is contingent upon the occurrence of various future events, which have a high degree of uncertainty of occurring. During the nine months ended September 30, 2012, the Company incurred $1.1 million in research and development expense associated with a research and development milestone under one of the Company’s other collaboration agreements. During the three months ended September 30, 2012, and the three and nine months ended September 30, 2011, there were no significant milestones achieved under the Company’s other collaborations.

5. Fair Value of Financial Instruments

The tables below present information about the Company’s assets that are measured at fair value on a recurring basis as of September 30, 2012 and December 31, 2011 and indicate the fair value hierarchy of the valuation techniques the Company utilized to determine such fair value. In general, fair values determined by Level 1 inputs utilize observable inputs such as quoted prices in active markets for identical assets or liabilities. Fair values determined by Level 2 inputs utilize data points that are either directly or indirectly observable, such as quoted prices, interest rates and yield curves. Fair values determined by Level 3 inputs utilize unobservable data points in which there is little or no market data, which require the Company to develop its own assumptions for the asset or liability.

The Company’s investment portfolio includes many fixed income securities that do not always trade on a daily basis. As a result, the pricing services used by the Company apply other available information as applicable through processes such as benchmark yields, benchmarking of like securities, sector groupings and matrix pricing to prepare valuations. In addition, model processes were used to assess interest rate impact and develop prepayment scenarios. These models take into consideration relevant credit information, perceived market movements, sector news and economic events. The inputs into these models may include benchmark yields, reported trades, broker-dealer quotes, issuer spreads and other relevant data.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The following tables present the assets the Company has measured at fair value on a recurring basis (in thousands):

Cash equivalents, accounts receivable, including related party accounts receivable, prepaid expenses and other current assets, accounts payable, accrued expenses and the current portion of capital lease obligations at September 30, 2012 and December 31, 2011 are carried at amounts that approximate fair value due to their short-term maturities.

The non-current portion of the capital lease obligations at September 30, 2012 and December 31, 2011 approximates fair value as it bears interest at a rate approximating a market interest rate.

6. Available-for-Sale Investments

The following tables summarize the available-for-sale securities held at September 30, 2012 and December 31, 2011 (in thousands):

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The contractual maturities of all securities held at September 30, 2012 are one year or less. There were ten investments classified as available-for-sale securities in an unrealized loss position at September 30, 2012, none of which had been in an unrealized loss position for more than twelve months. The aggregate fair value of these securities was approximately $16.8 million. There were 12 investments classified as available-for-sale securities in an unrealized loss position at December 31, 2011, none of which had been in an unrealized loss position for more than twelve months. The aggregate fair value of these securities was approximately $35.5 million. The Company reviews its investments for other-than-temporary impairment whenever the fair value of an investment is less than amortized cost and evidence indicates that an investment’s carrying amount is not recoverable within a reasonable period of time. To determine whether an impairment is other-than-temporary, the Company considers whether it has the ability and intent to hold the investment until a market price recovery and considers whether evidence indicating the cost of the investment is recoverable outweighs evidence to the contrary. The Company does not intend to sell the investments and it is not more likely than not that the Company will be required to sell the investments before recovery of their amortized cost bases, which may be maturity. The Company did not hold any securities with other-than-temporary impairment at September 30, 2012 or December 31, 2011.

The proceeds from maturities and sales of available-for-sale securities were $19.1 million and $70.5 million for the three months ended September 30, 2012 and 2011, respectively. Gross realized gains and losses on the sales of investments that have been included in other comprehensive income (loss) as well as net unrealized holding gains or losses for the period that have been included in accumulated other comprehensive income have not been material to the Company’s consolidated results of operations.

7. Inventory

Inventory consisted of the following at (in thousands):

In the third quarter of 2012, the Company began capitalizing inventory costs for linaclotide manufactured in preparation for its planned launch in the U.S. and Europe. Inventory at September 30, 2012 represents API that is available for commercial sale. As of September 30, 2012, the Company has not capitalized any inventory costs related to linaclotide manufactured for clinical trial use or its other drug development programs.

8. Accrued Expenses

Accrued expenses consisted of the following (in thousands):

9. Commitments and Contingencies

The Company leases its facility, offsite data storage location and various equipment under leases that expire at varying dates through 2018. Certain of these leases contain renewal options, and require the Company to pay operating costs, including property taxes, insurance and maintenance.

In January 2007, the Company entered into a lease agreement for 113,646 rentable square feet of office and lab space at 301 Binney Street, Cambridge, Massachusetts. The initial term of the lease is eight years expiring in January 2016, and the Company has the right to extend the initial term for two additional terms of five years each. The Company’s occupancy of the space occurred in four

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

distinct phases, and rent for each phase commenced at the earlier of a contractually set date or the occupancy date. Base rent for the space ranges from $49.25 to $60.50 per rentable square foot per year. Base rent escalated in January 2012 by 6.8% based upon a formula tied to the Consumer Price Index. The space was delivered to the Company in September 2007, and rent payments for the initial occupancy commenced in January 2008. The rent expense, inclusive of the escalating rent payments and free rent period is recognized on a straight-line basis over the term of the lease agreement. In accordance with the terms of the lease agreement, the Company maintains a letter of credit securing its obligations under the lease agreement of approximately $7.6 million.

The Company amended the lease agreement in February 2010, July 2010, February 2011, October 2011 and July 2012 (together “the Amendments”) in order to lease additional space. Pursuant to the Amendments, the Company leases an additional 96,613 rentable square feet of the 301 Binney Street building, comprised of (a) an initial phase of 35,444 rentable square feet (the “Initial Phase”), (b) a second phase of 21,589 rentable square feet (the “Second Phase”), (c) a third phase of 17,863 rentable square feet (the “Third Phase”) and (d) a fourth phase of 21,717 rentable square feet (the “Fourth Phase”). Rent for the Initial Phase commenced on July 1, 2010, rent for the Second Phase commenced on March 1, 2011, rent for the Third Phase commenced on January 1, 2012, and rent for the Fourth Phase commenced on June 1, 2012. Initial base rent for the Initial Phase is $42.00 per rentable square foot per year and the initial base rent for the Second Phase, Third Phase and Fourth Phase is $42.50 per rentable square foot per year. Base rent for the Initial Phase, Second Phase, Third Phase and Fourth Phase will increase annually by $0.50 per rentable square foot. Consistent with the Company’s treatment of the lease expense associated with the initial lease agreement, lease expense associated with the Amendments, inclusive of the escalating rent payments, is recognized on a straight-line basis over the term of the lease agreement. The Amendments do not change the expiration date of the lease agreement.

The landlord has reimbursed the Company for its tenant improvements for the space occupied prior to the Amendments at a set rate per rentable square foot. Under the terms of the Amendments, the landlord has or will provide the Company with an allowance for the additional space, which consists of $55.00 per rentable square foot for tenant improvements in the Initial Phase and the Second Phase and an allowance of $40.00 per rentable square foot for the Third Phase and the Fourth Phase. As of September 30, 2012, approximately $16.6 million has been paid to the Company as reimbursement for tenant improvements under the lease agreement, including the Amendments. The reimbursement amount is recorded as deferred rent on the condensed consolidated balance sheets and is being amortized as a reduction to rent expense over the term of the lease agreement or the Amendments, as applicable.

In October 2012, the Company entered into an amendment to its 301 Binney Street building lease, pursuant to which the Company will rent 93,000 square feet of additional space in four stages. Each stage will commence no later than December 1, 2013, June 1, 2014, June 1, 2015 and June 1, 2016, respectively. The amendment also extends the term of the entire lease agreement by 24 months. The Company’s operating lease obligations through January 2018 increased at least by an aggregate of $12.4 million as a result of this amendment.

The Company, and in some cases, along with its collaboration partner, Forest, has entered into multiple commercial supply agreements for the purchase of linaclotide API and drug product. Certain of the agreements contain minimum purchase commitments, the earliest of which commenced in 2012. As of September 30, 2012, the Company’s minimum purchase requirements and other firm commitments related to supply contracts are as follows: approximately $18.1 million, $7.3 million, $9.6 million, $9.7 million, $9.7 million and $5.9 million for the years ending December 31, 2012 (remaining 3 months), 2013, 2014, 2015, 2016 and 2017, respectively.

In January 2012, the Company executed a non-cancelable purchase order for drug-product manufacturing equipment in the amount of approximately $2.7 million, of which, the Company has paid approximately $0.8 million to date. The balance will be paid in increments upon the delivery of the equipment and upon the installation of the equipment, both anticipated to occur in the fourth quarter of 2012.

Guarantees

As permitted under Delaware law, the Company indemnifies its officers and directors for certain events or occurrences while the officer or director is, or was, serving at the Company’s request in such capacity. The maximum potential amount of future payments the Company could be required to make is unlimited; however, the Company has directors’ and officers’ insurance coverage that should limit its exposure and enable it to recover a portion of any future amounts paid.

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The Company is a party to a number of agreements entered into in the ordinary course of business that contain typical provisions that obligate the Company to indemnify the other parties to such agreements upon the occurrence of certain events. Such indemnification obligations are usually in effect from the date of execution of the applicable agreement for a period equal to the applicable statute of limitations. The aggregate maximum potential future liability of the Company under such indemnification provisions is uncertain.

The Company leases office space under a non-cancelable operating lease. The Company has a standard indemnification arrangement under the lease that requires it to indemnify its landlord against all costs, expenses, fines, suits, claims, demands, liabilities, and actions directly resulting from any breach, violation or nonperformance of any covenant or condition of the Company’s lease. The aggregate maximum potential future liability of the Company under such indemnification provisions is uncertain.

As of September 30, 2012 and December 31, 2011, the Company had not experienced any material losses related to these indemnification obligations and no material claims with respect thereto were outstanding. The Company does not expect significant claims related to these indemnification obligations and, consequently, concluded that the fair value of these obligations is negligible. As a result, the Company has not established any related reserves.

Litigation

From time to time, the Company is involved in various legal proceedings and claims, either asserted or unasserted, which arise in the ordinary course of business. While the outcome of these other claims cannot be predicted with certainty, management does not believe that the outcome of any of these ongoing legal matters, individually and in aggregate, will have a material adverse effect on the Company’s financial position.

10. Stockholders’ Equity

Common Stock

In February 2012, the Company sold 6,037,500 shares of its Class A common stock through a firm commitment, underwritten public offering at a price to the public of $15.09 per share. As a result of the offering, the Company received aggregate net proceeds, after underwriting discounts and commissions and other offering expenses, of approximately $85.2 million.

Restricted Stock

In 2009, the Company granted an aggregate of 515,549 shares of common stock to independent members of the board of directors under restricted stock agreements in accordance with the terms of the Company’s Amended and Restated 2005 Stock Incentive Plan (“2005 Plan”) and the Company’s director compensation program. 115,549 shares of restricted common stock granted in 2009 vested on December 31, 2009 and the remainder vest ratably over four years beginning in January 2010. In the event that a member of the board ceases to serve on the Company’s board prior to December 31, 2013, the member shall forfeit all unvested shares in accordance with the terms of the restricted stock agreement.

A summary of the unvested shares of restricted stock as of September 30, 2012 is presented below:

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

11. Stock Option Plans

The Company has several share-based compensation plans under which stock options, restricted stock, restricted stock units, and other share-based awards are available for grant to employees, directors and consultants of the Company. At September 30, 2012 and December 31, 2011, there were 7,199,949 shares and 6,222,981 shares, respectively, available for future grant under all of the plans.

In calculating share-based compensation costs, the Company estimated the fair value of stock options using the Black-Scholes option-pricing model. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived, exchange-traded options that have no vesting restrictions and are fully transferable. The Company estimates the number of awards that will be forfeited in calculating compensation costs. Such costs are then recognized over the requisite service period of the awards on a straight-line basis.

Determining the fair value of share-based awards using the Black-Scholes option-pricing model requires the use of highly subjective assumptions, including the expected term of the award and expected stock price volatility. The weighted-average assumptions used to estimate the fair value of the stock options using the Black-Scholes option-pricing model were as follows for the three and nine months ended September 30, 2012 and 2011:

The following table summarizes the expense recognized for these share-based compensation arrangements in the condensed consolidated statements of comprehensive income (loss) (in thousands):

Share-based compensation is reflected in the condensed consolidated statements of comprehensive income (loss) as follows for the three and nine months ended September 30, 2012 and 2011 (in thousands):

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

The following table summarizes stock option activity under the share-based compensation plans, including performance-based options:

(1)                                  All stock options granted under the 1998 Amended and Restated Stock Option Plan, the Amended and Restated 2002 Stock Incentive Plan and the 2005 Plan contain provisions allowing for the early exercise of such options into restricted stock. The exercisable shares disclosed above represent those that are vested as of September 30, 2012.

The weighted-average grant date fair value per share of options granted to employees during the three and nine months ended September 30, 2012 was approximately $6.21 and $7.01, respectively, and approximately $7.86 and $6.32 during the three and nine months ended September 30, 2011, respectively. The aggregate grant-date fair value of the options granted to employees during the three and nine months ended September 30, 2012 was approximately $1.9 million and $23.5 million, respectively, and approximately $2.7 million and $17.6 million during the three and nine months ended September 30, 2011, respectively. The total intrinsic value of options exercised during the three and nine months ended September 30, 2012 was approximately $1.3 million and $6.6 million, respectively, and approximately $2.6 million and $15.4 million during the three and nine months ended September 30, 2011, respectively.

As of September 30, 2012, there was approximately $0.5 million and $34.7 million of unrecognized share-based compensation, net of estimated forfeitures, related to restricted stock awards and unvested stock option grants with time-based vesting, respectively, which are expected to be recognized over a weighted-average period of 1.3 years and 3.2 years, respectively. The total unrecognized share-based compensation cost will be adjusted for future changes in estimated forfeitures.

The Company has granted to employees options to purchase shares of common stock subject to performance-based and time-accelerated milestone vesting. The vesting of the performance-based stock options occurs upon the achievement of certain performance-based milestones, and vesting of the time-accelerated stock options accelerates upon the achievement of certain performance-based milestones. During the three and nine months ended September 30, 2012, 100,000 shares and 132,500 shares vested as a result of milestone achievements, respectively, and the Company recorded related share-based compensation expense of approximately $0.7 million in both periods for these options. Additionally, as of September 30, 2012, the Company concluded that the achievement of two other milestones is probable. As a result, the Company recognized approximately $0.3 million of additional share-based compensation expense related to these performance-based and time-accelerated stock options. At September 30, 2012, the unrecognized share-based compensation related to performance-based milestone options was approximately $3.8 million. During the three and nine months ended September 30, 2011, no shares vested as a result of milestone achievement for either performance-based or time-accelerated stock options.

12. Related Party Transactions

The Company has and currently obtains legal services from a law firm that is an investor in the Company. The Company paid approximately $23,000 and $182,000 in legal fees to this investor during the three and nine months ended September 30, 2012, respectively, and approximately $29,000 and $124,000 during the three and nine months ended September 30, 2011, respectively. At September 30, 2012, the Company did not have accounts payable due to this related party.  At December 31, 2011, the Company had approximately $26,000 of accounts payable due to this related party.

In September 2009, Forest became a related party when the Company sold to Forest 2,083,333 shares of the Company’s

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Ironwood Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements (Continued)

(unaudited)

convertible preferred stock and in November 2009, Almirall became a related party when the Company sold to Almirall 681,819 shares of the Company’s convertible preferred stock (Note 4). These shares of preferred stock converted to the Company’s Class B common stock on a 1:1 basis upon the completion of the Company’s initial public offering in February 2010. Amounts due to and due from Forest and Almirall are reflected as related party accounts payable and related party accounts receivable, respectively. These balances are reported net of any balances due to or from the related party. At September 30, 2012, the Company had approximately $13,000 in related party accounts receivable associated with Almirall and $2.1 million in related party accounts payable, net of related party accounts receivable, associated with Forest. At December 31, 2011, the Company had approximately $15,000 in related party accounts receivable associated with Almirall and approximately $0.6 million in related party accounts receivable, net of related party accounts payable associated with Forest.

13. Subsequent Events

On October 23, 2012, the Company entered into a collaboration agreement with AstraZeneca under which the companies will jointly develop and commercialize linaclotide in China. Under the terms of the agreement, AstraZeneca will make an upfront payment of $25 million to Ironwood and will share the net profits and losses associated with linaclotide in China, with AstraZeneca receiving 55% of the net profit or incurring 55% of the net loss until a certain specified milestone is achieved, moving to an equal split thereafter. The Company is also eligible for $125 million in additional commercial milestone payments, contingent on the achievement of certain sales targets in China. In addition, Ironwood’s sales force will promote one of AstraZeneca’s products in the U.S.

In October 2012, the Company also entered into an amendment to its 301 Binney Street building lease (Note 9).

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Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

Forward-Looking Information

The following discussion of our financial condition and results of operations should be read in conjunction with our financial statements and the notes to those financial statements appearing elsewhere in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto and management’s discussion and analysis of financial condition and results of operations for the year ended December 31, 2011 included in our Annual Report on Form 10-K. This discussion contains forward-looking statements that involve significant risks and uncertainties. As a result of many factors, such as those set forth under “Risk Factors” in Part II, Item 1A of this Quarterly Report on Form 10-Q, which are incorporated herein by reference, our actual results may differ materially from those anticipated in these forward-looking statements.

Overview

We are an entrepreneurial pharmaceutical company dedicated to the art and science of great drugmaking. To achieve our mission, we are building a team, a culture and processes centered on creating and marketing differentiated medicines that provide clear and meaningful therapeutic benefits to patients. Our lead product, linaclotide, will be marketed in the United States, or U.S., under the trademarked name of LINZESS. On August 30, 2012, the United States Food and Drug Administration, or FDA, approved LINZESS as a once-daily treatment for adult men and women suffering from irritable bowel syndrome with constipation, or IBS-C, or chronic idiopathic constipation, or CIC. LINZESS is the first FDA-approved guanylate cyclase type-C, or GC-C, agonist, and it was shown in clinical trials to help relieve abdominal pain and constipation associated with IBS-C and improve constipation symptoms associated with CIC. We believe that LINZESS presents patients and healthcare practitioners with a unique therapy for a major medical need not yet met by existing therapies. LINZESS is being commercialized in the U.S. by us and our collaboration partner, Forest Laboratories, Inc., or Forest. We expect that LINZESS, a prescription product, will be commercially available in the U.S. in December 2012.

In September 2011, our European partner, Almirall, S.A, or Almirall, submitted a Market Authorization Application, or MAA, to the European Medicines Agency, or EMA, for linaclotide for the treatment of patients with IBS-C, and Almirall continues to work with the EMA in its review. On September 21, 2012, the EMA’s European Committee for Medicinal Products for Human Use, which provides non-binding recommendations for consideration by the EMA, issued a positive opinion recommending the marketing approval for linaclotide for the treatment of moderate to severe IBS-C in adults.

Astellas Pharma Inc., or Astellas, the Company’s partner in Japan and certain other Asian countries, continues to develop linaclotide for the treatment of patients with IBS-C in its territory.

We continue to assess alternatives to bring linaclotide to IBS-C and CIC sufferers in the parts of the world outside of its partnered territories. In May 2012, we submitted a Clinical Trial Application, or CTA, to China’s State Food and Drug Administration for a Phase 3 trial of linaclotide in patients with IBS-C. The CTA has been accepted for review. In October 2012, we also entered into a collaboration agreement with AstraZeneca AB, or AstraZeneca, to co-develop and co-commercialize linaclotide in China.

We continue to assess opportunities to expand the utility of linaclotide as well as the patient population who could benefit from linaclotide to ensure that we are maximizing the drug’s potential value. As part of our long-term strategy, we and Forest initiated a Phase 3b clinical trial to further characterize the effect of linaclotide on abdominal symptoms in patients with CIC. In addition, we continue to explore the potential for linaclotide in other patient populations as well as in other gastrointestinal indications.

We also have a pipeline focused on both research and development of early development candidates and discovery research in multiple therapeutic areas, including gastrointestinal disease, central nervous system, or CNS, disorders, respiratory disease and cardiovascular disease.

We have pursued a partnering strategy for commercializing linaclotide that has enabled us to retain significant control over linaclotide’s development and commercialization, share the costs with high-quality collaborators whose capabilities complement ours, and retain a significant portion of linaclotide’s future long-term value in the major pharmaceutical markets, should linaclotide meet our sales expectations.

We were incorporated in Delaware as Microbia, Inc. on January 5, 1998. On April 7, 2008, we changed our name to Ironwood Pharmaceuticals, Inc.

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We currently operate in one reportable business segment—human therapeutics. Our human therapeutics segment consists of the commercialization of our lead product, linaclotide, and the development and commercialization of our product candidates.

To date, we have dedicated substantially all of our activities to the research and development of linaclotide and our product candidates. We have not generated any revenue to date from product sales and have incurred significant operating losses since our inception in 1998. We generated net income of approximately $47.6 million in the three months ended September 30, 2012, and incurred a net loss of approximately $28.8 million in the nine months ended September 30, 2012. We incurred net losses of approximately $20.6 million and $57.9 million in the three and nine months ended September 30, 2011, respectively. As of September 30, 2012, we had an accumulated deficit of approximately $461.2 million, and we expect to incur losses for the foreseeable future.

In February 2012, we sold 6,037,500 shares of our Class A common stock through a firm commitment, underwritten public offering at a price to the public of $15.09 per share. As a result of the offering, we received aggregate net proceeds, after underwriting discounts and commissions and other offering expenses, of approximately $85.2 million.

Financial Overview

Revenue.  Revenue is generated primarily through our collaboration agreement with Forest, and our license agreements with Almirall and Astellas. The terms of these agreements contain multiple deliverables which may include (i) licenses, (ii) research and development activities, and (iii) the manufacture of active pharmaceutical ingredient, or API, and development materials for the collaborative partner. Payments to us may include one or more of the following: nonrefundable license fees; payments for research and development activities, payments for the manufacture of API and development materials, payments based upon the achievement of certain milestones and royalties on product sales. Additionally, we will receive 50% of the net profits or bear 50% of the net losses from the sale of LINZESS in the U.S, expected to begin in December 2012. We expect our revenue to fluctuate in the short term based on clinical and commercial milestones and based on the potential variability of demand for LINZESS upon commercial launch.

Research and development expense.  Research and development expense consists of expenses incurred in connection with the discovery, development, manufacture and distribution of our product candidates. These expenses consist primarily of compensation, benefits and other employee related expenses, research and development related facility costs and third-party contract costs relating to research, formulation, manufacturing, non-clinical study and clinical trial activities. We charge all research and development expenses to operations as incurred. Under our Forest collaboration agreement, we are reimbursed for certain research and development expenses, and we net these reimbursements against our research and development expenses as incurred.

Our lead product is linaclotide, and it represents the largest portion of our research and development expense for our product candidates. Linaclotide is the first FDA-approved GC-C agonist and is indicated for the treatment of IBS-C and CIC and is our only product, or product candidate, that has demonstrated clinical proof of concept. An NDA for LINZESS with respect to both IBS-C and CIC was approved by the FDA in August 2012.

We continue to assess opportunities to expand the utility of linaclotide as well as the patient population who could benefit from linaclotide to ensure that we are maximizing the drug’s potential value. As part of our long-term strategy, we and Forest initiated a Phase 3b clinical trial to further characterize the effect of linaclotide on abdominal symptoms in patients with CIC. In addition, we continue to explore the potential for linaclotide in other patient populations as well as in other gastrointestinal indications.

We also have a pipeline focused on both research and development of early development candidates and discovery research in multiple therapeutic areas, including gastrointestinal disease, CNS disorders, respiratory disease and cardiovascular disease.

The following table sets forth our research and development expenses related to our product pipeline for the three and nine months ended September 30, 2012 and 2011. These expenses relate primarily to external costs associated with manufacturing, including supply chain development, non-clinical studies and clinical trial costs. Costs related to facilities, depreciation, share-based compensation and research and development support services are not directly charged to programs.

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Since 2004, the date we began tracking costs by program, we have incurred approximately $169.3 million of research and development expenses related to linaclotide. The expenses for linaclotide include both reimbursements to us by Forest as well as our portion of research and development costs incurred by Forest for linaclotide and invoiced to us under the cost-sharing provisions of our collaboration agreement.

The lengthy process of securing regulatory approvals for new drugs requires the expenditure of substantial resources. Any failure by us to obtain, or any delay in obtaining, regulatory approvals would materially adversely affect our product development efforts and our business overall. In August 2012, the FDA approved our NDA for LINZESS as a once-daily treatment for adult men and women suffering from IBS-C and CIC. In connection with the FDA approval, we are required to conduct certain non-clinical and clinical studies aimed at understanding: (a) whether orally administered linaclotide can be detected in breast milk, (b) the potential for antibodies to be developed to linaclotide, and if so, (c) whether antibodies specific for linaclotide could have any therapeutic or safety implications. In addition, we and Forest established a non-clinical and clinical post-marketing plan with the FDA to understand LINZESS’s efficacy and safety in pediatric patients. In October 2012, we entered into a collaboration agreement with AstraZeneca under which we will jointly develop and commercialize linaclotide in China. We also are exploring the expansion of linaclotide in other parts of the world outside of our currently partnered territories, as well as the potential for linaclotide in other indications. Therefore, we cannot currently estimate with any degree of certainty the amount of time or money that we will be required to expend in the future on linaclotide in pediatrics, for other geographic markets or additional indications.  We also continue to advance our pipeline focused on early development candidates and discovery research in multiple therapeutic areas, including gastrointestinal disease, CNS disorders, respiratory disease and cardiovascular disease.  Given the inherent uncertainties that come with the development of pharmaceutical products, we cannot estimate with any degree of certainty how these programs will evolve, and therefore the amount of time or money that would be required to obtain regulatory approval to market them. As a result of these uncertainties surrounding the timing and outcome of any approvals, we are currently unable to estimate precisely when, if ever, linaclotide will be developed in pediatrics or for other indications or markets, or any of our other product candidates will generate revenues and cash flows.

We invest carefully in our pipeline, and the commitment of funding for each subsequent stage of our development programs is dependent upon the receipt of clear, supportive data. In addition, we are actively engaged in evaluating externally-discovered drug candidates at all stages of development. In evaluating potential assets, we apply the same criteria as those used for investments in internally-discovered assets.

The successful development of our product candidates is highly uncertain and subject to a number of risks including, but not limited to:

·                  The duration of clinical trials may vary substantially according to the type, complexity and novelty of the product candidate.

·                  The FDA and comparable agencies in foreign countries impose substantial requirements on the introduction of therapeutic pharmaceutical products, typically requiring lengthy and detailed laboratory and clinical testing procedures, sampling activities and other costly and time-consuming procedures.

·                  Data obtained from non-clinical and clinical activities at any step in the testing process may be adverse and lead to discontinuation or redirection of development activity. Data obtained from these activities also are susceptible to varying interpretations, which could delay, limit or prevent regulatory approval.

·                  The duration and cost of discovery, non-clinical studies and clinical trials may vary significantly over the life of a product candidate and are difficult to predict.

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·                  The costs, timing and outcome of regulatory review of a product candidate may not be favorable.

·                  The emergence of competing technologies and products and other adverse market developments may negatively impact us.

As a result of the uncertainties discussed above, we are unable to determine the duration and costs to complete current or future non-clinical and clinical stages of our product candidates or when, or to what extent, we will generate revenues from the commercialization and sale of our product candidates. Development timelines, probability of success and development costs vary widely. We anticipate that we will make determinations as to which additional programs to pursue and how much funding to direct to each program on an ongoing basis in response to the data of each product candidate, the competitive landscape and ongoing assessments of such product candidate’s commercial potential. As a result of the FDA’s approval of our NDA in August 2012, we expect that LINZESS will begin generating sales in the fourth quarter of 2012 upon commercial launch in the U.S.

We expect our research and development costs will be substantial for the foreseeable future. We will continue to invest in linaclotide including the areas of its supply chain and the exploration of its utility in other gastrointestinal and pain indications and other patient populations. We will also invest in our other product candidates as we advance them through non-clinical studies and clinical trials, in addition to funding full-time equivalents for research and development activities under our external collaboration and license agreements.

 General and administrative expense.    General and administrative expense consists primarily of compensation, benefits and other employee related expenses for personnel in our administrative, finance, legal, information technology, business development, commercial and human resource functions. Other costs include the legal costs of pursuing patent protection of our intellectual property, general and administrative related facility and IT infrastructure costs and professional fees for accounting and legal services. We anticipate substantial increases in expenses related to developing the organization necessary to commercialize linaclotide. We charge all general and administrative expenses to operations as incurred. Under our Forest collaboration agreement, we are reimbursed for certain general and administrative expenses, and we net these reimbursements against our general and administrative expenses as incurred.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations is based upon our consolidated financial statements prepared in accordance with generally accepted accounting principles in the U.S., or GAAP. The preparation of these financial statements requires us to make certain estimates and assumptions that affect the reported amounts of assets and liabilities, the reported amounts of revenues and expenses during the reported periods and related disclosures. These estimates and assumptions, including those related to revenue recognition, inventory valuation and related reserves, research and development expenses and share-based compensation are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. These critical estimates and assumptions are based on our historical experience, our observance of trends in the industry, and various other factors that are believed to be reasonable under the circumstances and form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from our estimates under different assumptions or conditions.

During the nine months ended September 30, 2012, we adopted Accounting Standards Update, or ASU, No. 2011-04, Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and IFRSs, or ASU 2011-04, ASU No. 2011-05, Presentation of Comprehensive Income, or ASU 2011-05, and ASU 2011-12, Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items Out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05, or ASU 2011-12, as discussed in Note 2, Summary of Significant Accounting Policies, to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q. There have been no significant changes to our critical accounting policies and estimates, including as a result of the adoption of these standards, with the exception of the development of the accounting estimates and assumptions inherent in inventory valuation and related reserves. Inventory is stated at the lower of cost or market with cost determined under the first-in, first-out basis. We evaluate inventory levels quarterly and any inventory that has a cost basis in excess of its expected net realizable value, inventory that becomes obsolete, inventory in excess of expected sales requirements or inventory that fails to meet commercial sale specifications is written down with a corresponding charge to cost of revenues in the period that the impairment is first identified. See Note 2 to our condensed consolidated financial statements included elsewhere in this Quarterly Report on Form 10-Q and in our Annual Report on Form 10-K filed with the Securities and Exchange Commission, or SEC, on February 29, 2012 for additional information about these critical accounting policies, as well as a description of our other significant accounting policies.

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Results of Operations

The following discussion summarizes the key factors our management believes are necessary for an understanding of our condensed consolidated financial statements.