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

CAUTIONARY STATEMENT REGARDING FORWARD-LOOKING STATEMENTS

This report contains certain statements that may be deemed ‘‘forward-looking statements’’ within the meaning of United States securities laws. All statements, other than statements of historical fact, that address activities, events or developments that we intend, expect, project, believe or anticipate will or may occur in the future are forward-looking statements. Such statements are based upon certain assumptions and assessments made by our management in light of their experience and their perception of historical trends, current conditions, expected future developments and other factors they believe to be appropriate. Factors that could cause results to differ materially from those projected or implied in the forward looking statements are set forth in our Annual Report on Form 10-K for the year ended December 31, 2006, as updated below under the caption ‘‘Item 1A — Risk factors’’. 

We encourage you to read those descriptions carefully. We caution you not to place undue reliance on the forward-looking statements contained in this report. These statements, like all statements in this report, speak only as of the date of this report (unless an earlier date is indicated) and we undertake no obligation to update or revise the statements except as required by law. Such forward-looking statements are not guarantees of future performance and actual results will likely differ, perhaps materially, from those suggested by such forward-looking statements.

In this report, ‘‘Cyclacel,’’ the ‘‘Company,’’ ‘‘we,’’ ‘‘us,’’ and ‘‘our’’ refer to Cyclacel Pharmaceuticals, Inc.

Overview

We are a development-stage biopharmaceutical company dedicated to the discovery, development and eventual commercialization of novel, mechanism-targeted drugs to treat human cancers and other serious disorders. Our core area of expertise is in cell cycle biology, or the processes by which cells divide and multiply. We focus primarily on the discovery and development of orally available anticancer agents that target the cell cycle with the aim of slowing the progression or shrinking the size of tumors, and enhancing quality of life and improving survival rates of cancer patients. We are generating several families of anticancer drugs that act on the cell cycle including Cyclin Dependent kinase (CDK) and Aurora kinase (AK) inhibitors. Although a number of pharmaceutical and biotechnology companies are currently attempting to develop CDK inhibitor drugs, we believe that our drug candidate, seliciclib, is the only orally available CDK inhibitor drug candidate currently in Phase IIb trials.

We are advancing three of our anticancer drug candidates, seliciclib, sapacitabine and CYC116 through in-house research and development activities. Seliciclib is currently being studied in a Phase IIb, multi-center, randomized, double-blinded trial to evaluate the efficacy and safety of seliciclib as a third line treatment in patients with non-small cell lung cancer (NSCLC). The APPRAISE study builds on the observation of prolonged stable disease experienced by heavily-pretreated NSCLC patients enrolled in a Phase I study of single agent seliciclib. We also plan to commence in 2007 a Phase II study of single agent seliciclib in nasopharyngeal carcinoma. Sapacitabine, our orally available nucleoside analog, has completed Phase I studies in approximately 150 patients at five centers in the United States. Sapacitabine has completed two Phase I studies evaluating 87 patients in refractory solid tumors. We are currently conducting a Phase Ib dose escalation clinical trial with sapacitabine for the treatment of patients with advanced malignancies with approximately 38 patients enrolled to date. Sapacitabine is planned to begin enter Phase II studies in 2007 in both hematological cancers and solid tumors. We announced the first study on April 30, 2007, when we initiated a Phase II clinical trial in patients with advanced cutaneous T-cell lymphoma. We are also developing CYC116, a novel inhibitor of Aurora kinases A and B and VEGFR2 for the treatment of cancer and we plan to commence Phase I clinical trials following the recent submission of an investigational new drug application to the Federal Drug Application. We have worldwide rights to commercialize seliciclib, sapacitabine and CYC116 and our business strategy is to enter into selective partnership arrangements with these programs. We are also progressing further novel drug series, principally for cancer, which are at earlier stages. Taken together, our pipeline covers all four phases of the cell cycle, which we

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believe will improve the chances of successfully developing and commercializing novel drugs that work on their own or in combination with approved conventional chemotherapies or with other targeted drugs to treat human cancers.

Our corporate headquarters is located in Berkeley Heights, New Jersey, with our main research facility located in the United Kingdom.

From our inception in 1996 through March 31, 2007, we have devoted substantially all our efforts and resources to our research and development activities. We have incurred significant net losses since inception. As of March 31, 2007, our accumulated deficit during the development stage was $143.2 million. We expect to continue incurring substantial losses for the next several years as we continue to develop our clinical, pre-clinical and other drugs currently in development. Our operating expenses comprise research and development expenses and general and administrative expenses.

To date, we have not generated any product revenue but have financed our operations and internal growth through private placements, licensing revenue, interest on investments, government grants and research and development tax credits. We have received proceeds from the issuances of equity interests of $166.8 million from inception through March 31, 2007 which includes $33.4 million raised from the registered direct offering through the sale of shares of common stock and warrants in the first quarter of 2007. Our revenue has consisted of collaboration and grant revenue. We have recognized revenues from inception through March 31, 2007 of $6.5 million of which $3.0 million is derived from fees under collaborative agreements and $3.5 million of grant revenue from various United Kingdom and European government grant awards. We have not generated any revenue from sales of commercial products and do not expect to generate any product revenue for the foreseeable future. We have also received $10.7 million from H.M. Revenue & Customs for research and development tax credits since inception.

Results of Operations

As explained in detail above in ‘‘5. Merger’’ the transaction with Xcyte was accounted for as a reverse merger and Cyclacel Limited was considered to have acquired Xcyte on March 27, 2006. As a consequence the comparative period for the three-month period ended March 31, 2006 reflects the results of Cyclacel Limited only while the current three-month period ended March 31, 2007 reflects the results of the combined companies from January 1, 2007 through March 31, 2007.

Revenues

The following table summarizes the components of our revenues for the three-month periods ended March 31, 2006 and 2007:

			Three months ended March 31,
			2006						2007						$ Difference						% Difference
			(unaudited)						(unaudited)
			(in thousands)
Collaboration and research and development revenue				$	95					$	10					$	(85	)					(89.5	)%
Grant revenue					56						42						(14	)					(25.0	)%
Total revenue				$	151					$	52					$	(99	)					(65.6	)%

Collaboration and research and development revenue is derived from several agreements under which the Company provides compounds for evaluation for an agreed consideration.

Grant revenue is recognized as we incur and pay for qualifying costs and services under the applicable grant. Grant revenue is primarily derived from various United Kingdom government grant awards.

Research and development expenses

To date, we have focused on drug discovery and development programs, with particular emphasis on orally available anticancer agents. Research and development expense represents costs incurred to

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discover and develop novel small molecule therapeutics, including clinical trial costs for seliciclib and sapacitabine, to advance product candidates toward clinical trials, to develop in-house research and preclinical study capabilities and to advance our biomarker program and technology platforms. We expense all research and development costs as they are incurred. Research and development expenses primarily include:

	•	payroll and personnel-related expenses, including consultants and contract research;

	•	clinical trial and regulatory-related costs;

	•	preclinical studies;

	•	screening and identification of drug candidates;

	•	laboratory supplies and materials;

	•	technology license costs;

	•	rent and facility expenses for our laboratories; and

	•	scientific consulting fees.

The following table provides information with respect to our research and development expenditure for the three-month periods ended March 31, 2006 and 2007:

			Three months ended March 31,
			2006						2007						$ Difference						% Difference
			(unaudited)						(unaudited)
			(in thousands)
Seliciclib				$	249					$	902					$	653						262.2	%
Sapacitabine					428						432						4						0.9	%
CYC116					1,831						481						(1,350	)					(73.7	)%
Other costs related to research and development programs, management and exploratory research					5,496						2,162						(3,334	)					(60.7	)%
Total research and development expenses				$	8,004					$	3,977					$	(4,027	)					(50.3	)%

Total research and development expenses represented 67.2% and 59.5% of our operating expenses for the three-month periods ended March 31, 2006, and 2007, respectively.

Research and development expenditure decreased 50.3% or $4.0 million from $8.0 million in the three-month period ended March 31, 2006 to $4.0 million in the three-month period ended March 31, 2007. The overall reduction relates primarily to; a decrease in the charge for stock-based compensation of $4.2 million (see further explanation below) and expenditure on CYC116 as the program was in full preclinical studies during 2006 offset by increases in seliciclib expenditure which commenced Phase IIb trials in June 2006.

Stock-based compensation expense attributable to research and development was $4.5 million and $0.3 million for the three-month periods ended March 31, 2006 and 2007, respectively.  Stock-based compensation is discussed below in greater detail.

The future

We plan to increase our investment in our research and development programs to further enhance our clinical and regulatory capabilities to allow us to advance the development of our drug candidates.

General and administrative expenses

General and administrative expenses include costs for administrative personnel, legal and other professional expenses and general corporate expenses. These costs are not broken out for reporting

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purposes. The following table summarizes the general and administrative expenses for the three-month periods ended March 31, 2006 and 2007:

			Three months ended March 31,
			2006						2007						$ Difference						% Difference
			(unaudited)						(unaudited)
			(in thousands)
Total general and administrative expenses				$	3,915					$	2,632					$	(1,283	)					(32.8	)

Total general and administrative expenses represented 32.8% and 39.3% of our operating expenses for the three-month periods ended March 31, 2006 and 2007, respectively.

Our general and administrative expenditure decreased $1.3 million from $3.9 million in the three-month period ended March 31, 2006 to $2.6 million in the three-month period ended March 31, 2007. The reduction in expenses was primarily attributable to a reduction in stock-based compensation cost of $2.1 million offset by an increase in other general and administrative expenses primarily related to the increased costs of operating as a public company of $0.8 million. This increase in costs was primarily due to $0.3 million for audit, accountancy and other costs related to regulatory filings, $0.2 million for compensation and recruitment.

There was an increase in restructuring costs of $0.1 million for additional accretion expense related to the Bothell lease.

Stock-based compensation related to general and administrative expense for the three-month periods ended March 31, 2006 and 2007 was $2.4 million and $0.3 million, respectively.  Stock-based compensation is discussed below in greater detail.

The future

As a public company, we operate in an increasingly demanding regulatory environment that requires us to comply with the Sarbanes-Oxley Act of 2002 and the related rules and regulations of the Securities and Exchange Commission, or SEC, and the Nasdaq Global Market for our common stock and Nasdaq Capital Market for our preferred stock, including those related to expanded disclosures, accelerated reporting requirements and more complex accounting rules. We expect that our general and administrative expenses will continue to increase in subsequent periods due to these requirements.

Stock based compensation expenses

We adopted SFAS 123R on January 1, 2006. Stock based compensation expenses includes charges/(credits) related to options issued to employees, directors and non-employees.

The following table summarizes the components of our stock based compensation for the three-month periods ended March 31, 2006 and 2007:

			Three months ended March 31,
			2006						2007						$ Difference						% difference
			(unaudited)						(unaudited)
			(in thousands)
Research and development related				$	4,546					$	290					$	(4,256	)					(93.6	)%
General and administrative related					2,425						253						(2,172	)					(89.6	)%
Total stock based compensation				$	6,971					$	543					$	(6,428	)					(92.2	)%

For the three-month periods ended March 31, 2006 and 2007 we recognized a stock-based compensation charge of $7.0 million and $0.5 million, respectively.

Our stock-based compensation charge for the three-month period ended March 31, 2006 of $7.0 million, is comprised of (i) $5.2 million related to restricted stock granted to certain employees and directors and (ii) $1.8 million due to the acceleration of vesting of options due to the Stock Purchase.

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In the first quarter of 2007, we granted 256,250 stock options to our non-executive directors under the 2006 Plans which vest ratably over the four years to March 8, 2011. Our stock-based compensation charge for the three-month period ended March 31, 2007 of $0.5 million, relates to options granted in 2006 and the first quarter of 2007 under the 2006 Plans.

The future

We may from time to time continue to grant options or other stock-based awards, which will result in an expense, to our employees, directors and, as appropriate, to non-employee service providers. In addition, previously-granted options will continue to vest in accordance with their terms. The total fair value of all options granted under the 2006 Plans is $6,704,000. In respect of these options, $3,642,000 of compensation expense has not been recognized at March 31, 2007.

Restructuring charge

The following table summarizes the restructuring charges for the three-month periods ended March 31, 2006 and 2007:

			Three months ended March 31,
			2006						2007						$ Difference						% difference
			(unaudited)						(unaudited)
			(in thousands)
Total restructuring charge				$	—					$	80					$	80						—

In March 2006, the Company assumed an accrued restructuring liability in relation to the Bothell manufacturing facility, calculated as the net present value of the difference between the remaining lease payments due less the estimate of net sublease income and expenses. In September 2006, the Company entered into an Exclusive Subleasing Agency Agreement in an attempt to achieve the successful sublet of the facility. The current market assessment from our real estate agent is that it remains difficult to lease space in the Bothell area and the original estimate of obtaining an early tenant was optimistic. On the basis that the real estate agents projected an improvement in the real estate market in 2007 we assessed that the facility may have a possibility of being sub let by the beginning of 2008, albeit at a reduced capacity. As a result of this, we have recorded an additional provision in the first quarter of 2007 of $80,000 in recognition of reduced projected sub-lease income sublease agreement. No such restructuring expense was recognized in the three-month period ended March 31, 2006.

Future

As at March 31, 2007 the restructuring liability associated with exiting the Bothell facility was $2.2 million accounting for the estimated fair value of the remaining lease payments, net of estimated sub-lease income. The restructuring liability is subject to a variety of assumptions and estimates. We review these assumptions and estimates on a quarterly basis and will adjust the accrual if necessary. These changes can be material.

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Other income (expense)

Other income (expense) is comprised of the change in valuation of the derivative, change in the valuation of the warrants, interest income and interest expense. The following table summarizes the other income (expense) for the three-month periods ended March 31, 2006 and 2007:

			Three months ended March 31,
			2006						2007						$ Difference						% difference
			(unaudited)						(unaudited)
			(in thousands)
Change in valuation of derivative				$	—					$	(40	)				$	(40	)					(100.0	)%
Change in valuation of warrants					—						458						458						100.0	%
Interest income					127						828						701						552.0	%
Interest expense					(68	)					(51	)					17						(25.0	)%
Total other income (expense)				$	59					$	1,195					$	1,136						1,925.4	%

The change in derivative value of $40,000 during the three-month period ended March 31, 2007 is associated with the dividend make-whole payment on our outstanding convertible exchangeable preferred stock. No such derivative valuation expense was recognized during the three-month period ended March 31, 2006.

The change in valuation of warrants relates to the issue of warrants to purchase shares of common stock under the registered direct financing completed in February 2007. We have concluded that the warrants must be liability-classified and the Company recorded the fair value of the warrants as long-term liabilities. The fair value of the outstanding warrants is evaluated at each reporting period with any resulting change in the fair value being reflected in the consolidated statements of operations. The change in fair value recognized in the financial statements during the first quarter of 2007 was $458,000.

The increase in interest income of $0.7 million from $0.1 million during the three-month period ended March 31, 2006 to $0.8 million during the three-month period ended March 31, 2007 is primarily attributable to higher average balances of cash and cash equivalents and short-term investments throughout the second, third and fourth quarters of 2006 following receipt of $42.6 million, being the proceeds of our private placement in the second quarter and the $21.6 million of cash and cash equivalents and short-term investments assumed on the Stock Purchase, and the first quarter of 2007 following the receipt of $33.4 million being the proceeds of our registered direct offering in February 2007.

Interest expense in the three-month period ended March 31, 2007 has decreased by $17,000 as compared to the same period in 2006. During the three-month period ended March 31, 2006 interest expenses resulted primarily from interest associated with a government loan, the principal of which was repaid in the fourth quarter of 2005. No such interest expense was recognized in the three-month period ended March 31, 2006. During the three-month period ended March 31, 2007 interest expenses resulted primarily from accretion expense associated with the Bothell lease restructuring provision. No such accretion expense was recognized in the three-month period ended March 31, 2006.

The future

The valuation of the dividend make-whole payment will continue to be re-measured at the end of each reporting period. The valuation of the derivative is dependent upon many factors, including estimated market volatility, and may fluctuate significantly, which may have a significant impact on our statement of operations.

The valuation of the liability-classified warrants will continue to be re-measured at the end of each reporting period. The valuation of the warrants is dependent upon many factors, including estimated market volatility, and may fluctuate significantly, which may have a significant impact on our statement of operations.

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A further $0.3 million of accretion expense associated with the Bothell lease restructuring charge will be recognized over the remaining life of the lease through November 2010.

Income tax benefit

Credit is taken for research and development tax credits, which are claimed from the United Kingdom’s taxation and customs authority, in respect of qualifying research and development costs incurred.

The following table summarizes research and development tax credits for the three-month periods ended March 31, 2006 and 2007:

			Three months ended March 31,
			2006						2007						$ Difference						% difference
			(unaudited)						(unaudited)
			(in thousands)
Total income tax benefit				$	360					$	552					$	192						53.3	%

Research and development tax credits recoverable have increased by $0.2 million from $0.4 million during the three-month period ended March 31, 2006 to $0.6 million during the three-month period ended March 31, 2007. This increase was a reflection of an increase in income taxes available for recovery. The increased income taxes available to recover relate to taxes paid in connection with bonuses accrued in 2006 and paid to directors and employees in the first quarter of 2007.

Future

We expect the company to continue to be eligible to receive United Kingdom research and development tax credits for the foreseeable future and will elect to do so.

Liquidity and Capital Resources

The following is a summary of our key liquidity measures as at March 31, 2006 and 2007:

			March 31, 2006						March 31, 2007						$ Difference						% Difference
			(Unaudited)						(Unaudited)
			(in thousands)
Cash and cash equivalents				$	23,707					$	75,215					$	51,508						217.3	%
Short-term investments, available for sale					6,918						5,536						(1,382	)					(20.0	)%
Total cash and cash equivalents and short-term investments, available for sale				$	30,625					$	80,751					$	50,126						163.7	%
Current assets				$	34,003					$	85,231					$	51,228						150.7	%
Current liabilities					10,951						6,579						(4,372	)					(39.9	)%
Working capital				$	23,052					$	78,652					$	55,600						241.2	%

We believe that existing funds together with cash generated from operations are sufficient to satisfy our planned working capital, capital expenditures, debt service and other financial commitments at least through 2008.

At March 31, 2007, we had cash and cash equivalents and short-term investments of $80.8 million. Since our inception, we have not generated any significant product revenue and have relied primarily on the proceeds from sales of equity and preferred securities to finance our operations and internal growth. Additional funding has come through interest on investments, licensing revenue, government grants and research and development tax credits. We have incurred significant losses since our inception. As of March 31, 2007, Cyclacel had an accumulated deficit of $143.2 million.

At March 31, 2006, we had cash and cash equivalents and short-term investments of $30.6 million, as compared to $80.8 million at March 31, 2007. This higher balance at March 31, 2007 was primarily due

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to the receipt of net proceeds of $42.6 million from the private placement in the second quarter of 2006 and the receipt of net proceeds of $33.4 million from the registered direct offering in the first quarter of 2007.

The following is a summary of our contractual obligations and other commitments relating to our facilities, equipment leases and purchases as at March 31, 2007, and the effect such obligations could have on our liquidity:

									Payments due by period
			Total						Less than 1 year						1-3 years						4-5 years						After 5 years
			(in thousands)
Capital lease obligations				$	19					$	19					$	—					$	—					$	—
Operating lease obligations					9,198						2,154						4,336						2,196						512
Purchase obligations					2,146						2,146						—						—						—
Total				$	11,363					$	4,319					$	4,336					$	2,196					$	512

We also currently have a number of contractual arrangements with our partners under which milestone payments totaling $23.4 million would be payable subject to achievement of all the specific contractual milestones and our decision to continue with these projects. Under these contractual arrangements, we make annual payments that do not and will not exceed $0.1 million.

Cash provided by (used in) operating , investing and financing activities for the three-month periods ended March 31, 2006 and 2007, is summarized as follows:

			Three months ended March 31,
			2006						2007
			(Unaudited)						(Unaudited)
			(in thousands)
Net cash used in operating activities				$	(2,336	)				$	(6,063	)
Net cash provided by investing activities				$	7,135					$	4,107
Net cash provided by financing activities				$	15,902					$	32,980

Operating activities

Net cash used in operating activities increased $3.7 million, from $2.3 million in the three-month period ended March 31, 2006 to $6.0 million in the three-month period ended March 31, 2007.

Net cash used in operating activities during the three-month period ended March 31, 2006 of $2.3 million resulted from our net operating loss of $11.3 million, adjusted for material non-cash activities comprising depreciation and amortization, and non-cash stock based compensation expense, amounting to $7.2 million, and net increase in working capital of $1.8 million, primarily due to a net increase in accounts payable and accrued expenses.

Net cash used in operating activities during the three-month period ended March 31, 2007 of $6.1million resulted from our net operating loss of $4.9 million, adjusted for material non-cash activities comprising amortization of investment premiums (discounts), change in valuation of derivative, change in valuation of liability-classified warrants, depreciation and amortization, non-cash stock based compensation expense and provision for restructuring costs, amounting to $0.4 million and net decrease in working capital due to a decrease in amounts receivable combined with a net decrease in accounts payable and accrued expenses.

Investing activities

Net cash provided by investing activities decreased $3.0 million, from $7.1 million in the three-month period ended March 31, 2006 to $4.1 million in the three-month period ended March 31, 2007.

Net cash provided by investing activities during the three-month periods ended March 31, 2006 and 2007 resulted primarily from the sale and maturity of our short-term investments, the proceeds of which were used to fund our operating activities.

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Capital spending is vital to our research and development initiatives and to maintain our operational capabilities. During the three-month periods ended March 31, 2006 and 2007 we used cash of $0.1 million in each period to develop our research facilities in both Dundee, Scotland and Cambridge, England, to acquire smaller, but key items, of research and development equipment and replacement items essential to support our information technology function and to complete the refurbishment of our new corporate head quarters in Berkeley Heights, New Jersey.

Financing activities

Net cash provided by financing activities increased $17.1 million, from $15.9 million in the three-month period ended March 31, 2006 to $33.0 million in the three-month period ended March 31, 2007.

During the three-month period ended March 31, 2006 the net cash provided by financing activities related primarily to the $21.6 million of cash, cash equivalents and short term investments assumed on the Stock Purchase offset by costs associated with the Stock purchase of $2.0 million and the payment of capital lease obligations.

During the three-month period ended March 31, 2007 the net cash provided by financing activities related to $33.4 million in net proceeds from our registered direct financing, offset by the payment of our preferred stock dividend of $0.3 million and by payment of capital lease obligations.

Operating Capital and Capital Expenditure Requirements

We expect to continue to incur substantial operating losses in the future. We will not receive any product revenue until a product candidate has been approved by the U.S. Food and Drug Administration (‘‘FDA’’) or similar regulatory agencies in other countries and successfully commercialized. We currently anticipate that our cash, cash equivalents, marketable securities and proceeds from the private placement will be sufficient to fund our operations at least through 2008. However, we will need to raise substantial additional funds to continue our operations. We cannot be certain that any of our programs will be successful or that we will be able to raise sufficient funds to complete the development and commercialize any of our product candidates currently in development, should they succeed. Additionally, we plan to continue to evaluate in-licensing and acquisition opportunities to gain access to new drugs or drug targets that would fit with our strategy. Any such transaction would likely increase our funding needs in the future.

Our future funding requirements will depend on many factors, including but not limited to:

	•	the rate of progress and cost of our clinical trials, preclinical studies and other discovery and research and development activities;

	•	the costs associated with establishing manufacturing and commercialization capabilities;

	•	the costs of acquiring or investing in businesses, product candidates and technologies;

	•	the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

	•	the costs and timing of seeking and obtaining FDA and other regulatory approvals;

	•	the effect of competing technological and market developments; and

	•	the economic and other terms and timing of any collaboration, licensing or other arrangements into which we may enter.

Until we can generate a sufficient amount of product revenue to finance our cash requirements, which we may never do, we expect to finance future cash needs primarily through public or private equity offerings, debt financings or strategic collaborations. We do not know whether additional funding will be available on acceptable terms, or at all. If we are not able to secure additional funding when needed, we may have to delay, reduce the scope of or eliminate one or more of our clinical trials or research and development programs. In addition, we may have to partner one or more of our product candidate programs at an earlier stage of development, which would lower the economic value of those programs to our company.

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Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses and related disclosure of contingent assets and liabilities. We review our estimates on an ongoing basis. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances. Actual results may differ from these estimates under different assumptions or conditions. While our significant accounting policies are described in more detail in the notes to our financial statements included in this document, we believe the judgments and estimates required by the following accounting policies to be critical in the preparation of our financial statements.

Stock-based Compensation

On January 1, 2006, we adopted SFAS 123R. Under SFAS 123R, the fair value of stock options and other equity-based compensation must be recognized as expense in the statements of operations over the requisite service period of each award. Prior to January 1, 2006, we accounted for stock-based employee compensation arrangements in accordance with the provisions of APB No. 25, SFAS No. 123 and complied with the disclosure requirements of SFAS No. 148. Under APB No. 25, compensation expense is based on the difference, if any, on the date of grant, between the estimated fair value of our ordinary shares and the exercise price. SFAS 123R defines a ‘‘fair value’’ based method of accounting for an employee stock option or similar equity investment.

Derivative Instruments

The terms of our November 2004 convertible preferred stock offering include a dividend make-whole payment feature. If we elect to automatically convert, or the holder elects to voluntarily convert, some or all of the convertible preferred stock into shares of our common stock prior to November 3, 2007, we will make an additional payment on the convertible preferred stock equal to the aggregate amount of dividends that would have been payable on the convertible preferred stock through and including November 3, 2007, less any dividends already paid on the convertible preferred stock. This additional payment is payable in cash or, at our option, in shares of our common stock, or a combination of cash and shares of common stock. This dividend make-whole payment feature is considered to be an embedded derivative and has been recorded on the balance sheet at fair value as a current liability. We will be required to recognize other income (expense) in our statements of operations as the fair value of this derivative fluctuates from period to period.

The accounting for derivatives is complex, and requires significant judgments and estimates in determining the fair value in the absence of quoted market values. These estimates are based on valuation methodologies and assumptions deemed appropriate in the circumstances. The fair value of the dividend make-whole payment feature is based on various assumptions, including the estimated market volatility and discount rates used in determination of fair value. The use of different assumptions may have a material effect on the estimated fair value amount and our results of operations.

Goodwill

Goodwill represents the difference between the purchase price and the fair value of net tangible and identifiable intangible assets acquired in the business combination.

In July 2001, the Financial Accounting Standards Board (‘‘FASB’’) issued Statement of Financial Accounting Standards (‘‘SFAS’’) No. 141, ‘‘Business Combinations,’’ and SFAS No. 142, ‘‘Goodwill and Other Intangible Assets’’. Under SFAS No. 141, all business combinations initiated after June 30, 2001 must be accounted for using the purchase method. Under SFAS No. 142, goodwill and intangible assets with indefinite lives are no longer amortized but are reviewed annually (or more frequently if

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there are indicators such assets may be impaired) for impairment. Separable intangible assets that are not deemed to have indefinite lives will continue to be amortized over their estimated useful lives. There were no triggering events calling into question the recoverability of goodwill during the three-month period ended March 31, 2007.

Warrants liability

Emerging Issues Task Force (‘‘EITF’’) 00-19, ‘‘Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock’’ requires freestanding contracts that are settled in a Company’s own stock, including common stock warrants to be designated as an equity instrument, asset or liability. Under the provisions of EITF 00-19, a contract designated as an asset or a liability must be carried at fair value until exercised or expired, with any changes in fair value recorded in the results of operations. A contract designated as an equity instrument must be included within equity, and no fair value adjustments are required. The Company reviews the classification of its contracts at each balance sheet date.

Pursuant to EITF Issue No. 00-19, since the Company is unable to control all the events or actions necessary to settle the warrants in registered shares the warrants have been recorded as long-term liabilities at fair value. The fair value of the outstanding warrants is evaluated at each reporting period with any resulting change in the fair value being reflected in the consolidated statements of operations. The change in fair value recognized in the financial statements during the first quarter of 2007 was $458,000.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

We are exposed to market risk related to fluctuations in interest rates and in foreign currency exchange rates.

Interest Rate Risk

Our short-term investments as of March 31, 2007 consisted of $1.9 million in corporate bonds and $3.6 million in federal agency obligations with contractual maturities of one year or less. Due to the short-term nature of our investments, we believe that our exposure to market interest rate fluctuations is minimal. The corporate bonds in which we invest are rated ‘‘A’’ or better by both Moody’s and Standard and Poor’s. Our cash and cash equivalents are held primarily in highly liquid money market accounts. A hypothetical 10% change in short-term interest rates from those in effect at March 31, 2007 would not have a significant impact on our financial position or our expected results of operations. We do not currently hold any derivative financial instruments with interest rate risk.

Foreign Currency Risk