Number of Shares				Exercise Price			Expiration Date
	350,000			$	0.28		November 2010
	2,126,668			$	0.28		May 2012
	43,614,285			$	0.28		October 2016
	20,000			$	0.39		September 2014
	50,000			$	0.35		May 2011
	15,000			$	0.50		September 2014
	15,000			$	0.60		September 2014
	7,000,000			$	0.75		June 2011
	50,000			$	1.00		May 2011
	50,000			$	1.50		May 2011
	50,000			$	2.00		May 2011
	50,000			$	2.50		May 2011
	50,000			$	0.38		April 2020
	53,440,953			$	0.35

Below is a summary of warrant activity for the nine months ended June 30, 2010:

 

						Weighted Average
										Remaining Contractual				Aggregrate
		Number of Shares				Exercise Price				Term (in years)				Intrinsic Value
Outstanding at 9/30/2009			27,379,525			$	0.46				3.25			$	1,051,248
Granted			43,664,285			$	0.28				6.27			$	5,234,714
Exercised			(60,000	)		$	0.28				1.89			$	9,000
Expired or Canceled			(17,542,857	)		$	0.36				3.27			$	927,643
Forfeited						$	0.00							$	0
Vested RSAs
Outstanding at 6/30/2010			53,440,953			$	0.35				5.33			$	5,532,114

 

As discussed previously, the Warrants expiring in November 2010, May 2012 and October 2016 are deemed to be liabilities and as such are carried at their fair value as a liability on the Balance Sheet.

G.         Stock-Based Compensation

Below is a summary of stock option activity for the nine months ended June 30:

 

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						Weighted Average
		Number of								Remaining Contractual				Aggregrate
		Shares				Exercise Price				Term (in years)				Intrinsic Value
Outstanding at 9/30/2009			6,175,015			$	1.58				6.96			$	137,913
Granted			185,000			$	0.35				9.53			$	8,825
Exercised						$	0.00				0.00			$	0
Expired or Canceled			(1,200	)		$	51.25				0.00			$	0
Forfeited			(421,250	)		$	0.62							$	4,500
Vested (RSAs)
Outstanding at 6/30/2010			5,937,565			$	1.60				6.24			$	163,775

For the nine months ended June 30, 2010 and 2009, all stock options were issued with an exercise price at or above the fair market value of the Company’s common stock on the date of grant.

The details of stock options for the nine months ended June 30, 2010 were as follows:

 

				Options Outstanding												Options Exercisable
				Number				Weighted				Weighted Average				Number				Weighted
Range of				Outstanding at				Average Exercise				Remaining				Exercisable at June				Average Exercise
Exercise Prices				June 30, 2010				Price				Contractual Life				30, 2010				Price
$	0.29-0.32				1,526,250			$	0.30				8.72				1,509,583			$	0.30
$	0.33-0.45				903,500			$	0.39				8.82				784,545			$	0.39
$	0.55-0.75				768,111			$	0.65				6.41				768,111			$	0.65
$	0.78-0.90				794,335			$	0.87				5.91				794,335			$	0.87
$	0.91-1.50				1,382,019			$	1.46				3.25				1,382,019			$	1.46
	1.52				2,500			$	1.52				4.25				2,500			$	1.52
$	1.55-2.10				211,750			$	1.85				4.22				211,750			$	1.85
$	2.50-11.50				188,624			$	4.95				3.27				188,624			$	4.95
$	12.85-20.00				79,754			$	15.10				1.09				79,754			$	15.10
$	22.50-51.25				80,722			$	36.75				0.15				80,722			$	36.75
$	0.29-51.25				5,937,565			$	1.60				6.23				5,801,943			$	1.63

 

Stock-based compensation expense recognized in the statement of operations is as follows (in thousands):

		For the three months ended June 30,			For the nine months ended June 30,
		2010	2009		2010	2009
Research and Development Expenses		8	11		41	34
General and Administrative Expenses		79	71		366	159
		87	82		407	193

 

The total deferred compensation expense for outstanding and unvested stock options for the nine months ended June 30, 2010 was approximately $32,000.  The weighted average remaining recognition period for the total deferred compensation expense is approximately six months. The fair value of the options associated with the above compensation expense was determined at the date of the grant using the Black-Scholes option pricing model with the following weighted average assumptions:

		For the nine months ended June 30
		2010		2009
Dividend yield		0%		0%
Expected volatility		95% - 96%		96%– 209%
Risk-free interest rate		3.3% - 3.5%		2.6% - 3.8%
Expected term		10 years		10 years

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H.           Commitments

The Company has acquired assets still in development and entered into research and development arrangements with third parties that may require milestone and royalty payments to the third party contingent upon the occurrence of certain future events linked to the success of the asset in development. Milestone payments may be required, contingent upon the successful achievement of an important point in the development life-cycle of the pharmaceutical product (e.g., approval of the product for marketing by a regulatory agency). If required by the arrangement, the Company may have to make royalty payments based upon a percentage of the sales of the pharmaceutical product in the event that regulatory approval for marketing is obtained.

These arrangements may be material individually, and in the unlikely event that milestones for multiple products covered by these arrangements were reached in the same period, the aggregate charge to expense could be material to the results of operations in any one period. In addition, these arrangements often give Aeolus the discretion to unilaterally terminate development of the product, which would allow Aeolus to avoid making the contingent payments; however, Aeolus is unlikely to cease development if the compound successfully achieves clinical testing objectives.

I.           Subsequent Events

On July 30, 2010, the Company exercised the “Put Option” granted by the Investors to the Company in the October 2009 financing.  As a result of the exercise, the Company received $1.65 million in gross proceeds from the investors in exchange for 5,892,857 additional Units (the “Additional Units”), comprised of an aggregate of 5,892,857 shares of Common Stock and warrants to purchase up to an aggregate of 11,785,714 additional shares of common stock at a purchase price of $0.28.  Cash proceeds from the put exercise are expected to be $1.63 million after legal costs associated with the exercise and subsequent issuance of stock and warrants.

On July 30, 2010, the Company and Mr. John McManus amended and restated Mr. McManus’ employment agreement, dated July 14, 2006, with the Company. Under the Amended and Restated Employment Agreement (the “Restated Agreement”), Mr. McManus will continue to serve as President, Chief Executive Officer and Chief Operating Officer of the Company. Pursuant to the agreement, Mr. McManus will be paid $20,850 a month. However, in the event, on or prior to June 30, 2011, the Company (i) enters into one or more binding agreements for the sale and issuance of equity of the Company in one or more financings, (ii) enters into one or more binding partnership, licensing, collaboration, development or similar agreements, or (iii) is awarded one or more grants or contracts, all of which taken together collectively entitle the Company to receive gross proceeds of at least $10,000,000 (the “Threshold Amount”) (excluding any proceeds received from the Investors or any affiliate thereof), Mr. McManus’ salary shall be increased to $33,333 per month, effective as of the date of such agreement or award, when combined with all prior agreements or awards, entitles the Company to the Threshold Amount.

 

On August 12, 2010, the Company announced an additional financing with existing investors.  Under the terms of the August 2010 Financing agreement, Aeolus received $1 million in gross proceeds in exchange for the issuance of 2.5 million shares of common stock and warrants to purchase up to 1,875,000 shares at an exercise price of $0.50 per share.   The Company also granted to the August 2010 Investors the option to acquire, collectively, up to an additional 2,500,000 Additional Units, comprised of an aggregate of 2,500,000 shares of Common Stock and warrants to purchase up to an aggregate of 1,875,000 additional shares of common stock at an exercise price of $0.50 (the “Call Option”). In addition, the August 2010 Investors granted to the Company the option to require these August 2010 Investors, severally and not jointly, to acquire up to 2,500,000 Additional Units, less any Additional Units acquired under the Call Option, at the per Additional Unit purchase price of $0.40 (the “Put Option”).  The Call Option is exercisable at any time, and from time to time, on or prior to December 31, 2010.  The Put Option is exercisable at any time from November 30, 2010 to December 30, 2010.  However, the Investors shall have the right to terminate the Put Option if they reasonably determine that a material adverse event, condition or circumstance has occurred with respect to the prospects of the Company’s AEOL 10150 drug candidate for acute radiation syndrome; provided that the Company’s failure to receive a grant or financing shall not, by itself, constitute a material adverse event, condition or circumstance with respect thereto.

Management has evaluated for subsequent events through the date these financial statements were filed and determined that no other material subsequent events have occurred.

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

Introduction

Unless otherwise noted, the terms “we,” “our” or “us” refer collectively to Aeolus Pharmaceuticals, Inc. and our wholly owned subsidiary, Aeolus Sciences, Inc.

 

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This report contains, in addition to historical information, statements by us with respect to expectations about our business and future results which are “forward-looking” statements under the Private Securities Litigation Reform Act of 1995. These statements and other statements made elsewhere by us or by our representatives, which are identified or qualified by words such as “likely,” “will,” “suggests,” “expects,” “might,” “believe,” “could,” “should,” “may,” “estimates,” “potential,” “predict,” “continue,” “would,” “anticipates,” “plans,” or similar expressions, are based on a number of assumptions that are subject to risks and uncertainties. Such statements include, but are not limited to, those relating to Aeolus’ product candidates, as well as its proprietary technologies and uncertainties and other factors that may cause Aeolus’ actual results to be materially different from historical results or from any results expressed or implied by such forward-looking statements. Important factors that could cause results to differ include risks associated with uncertainties of progress and timing of clinical trials, scientific testing, obtaining regulatory approval, the need to obtain funding for pre-clinical and clinical trials and operations, the scope and validity of intellectual property protection for Aeolus’ product candidates, proprietary technologies and their uses, new accounting and SEC requirements and competition from other biopharmaceutical companies. Certain of these factors and others are more fully described in Aeolus’ filings with the SEC, including, but not limited to, Aeolus’ Annual Report on Form 10-K for the fiscal year ended September 30, 2009.  All forward-looking statements are based on information available as of the date hereof, and we do not assume any obligation to update such forward-looking statements. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.

Operations Summary

We are developing a new class of catalytic antioxidant compounds as a medical countermeasure against biological, chemical and radiological weapons as well as for diseases and disorders of the central nervous system, respiratory system, autoimmune system and oncology.  Our initial target indications are as a protective agent against the effects of acute radiation syndrome, sulfur mustard gas exposure and chlorine gas exposure.  We have reported positive safety results from two Phase I clinical trials of AEOL 10150, our lead drug candidate, with no serious adverse events noted.

On May 12, 2010, the Company was notified by Chemical Biological Medical Systems that it had not been awarded a contract for development of AEOL 10150 as a countermeasure for GI-Acute Radiation System.  Development of the compound for GI-ARS continues and continues to be funded by the National Institutes of Health (NIH) – National Institutes of Allergies and Immunological Disorders (NIAID).   The decision by CBMS does not have a financial impact on the Company as funding from CBMS was not considered as a component of Aeolus’ programs for budgeting purposes.  Review of the Company’s proposal for a contract with the Biologic Advanced Research and Development Authority (BARDA) for development of AEOL 10150 in Lung ARS continues.

We do not have any revenue, other than grant income, and therefore we must rely on public or private equity offerings, debt financings, collaboration arrangements or grants to finance our operations.

Need for Additional Funds

With the financings announced in July and August 2010 (see subsequent events), we believe we have adequate financial resources to fund our operations into the first half of fiscal year 2012.  In order to fund on-going operating cash requirements beyond the first half of fiscal year 2012, or to accelerate or expand our programs, however, we may need to raise significant additional funds. Our need for additional financing is discussed under “Liquidity and Capital Resources”, and is updated in Subsequent Events.

Results of Operations

Three months ended June 30, 2010 versus three months ended June 30 2009

We had a net loss of approximately $4,623,000 for the three months ended June 30, 2010, versus a net loss of approximately $426,000 for the three months ended June 30, 2009.   Of the loss for the three months ended June 30, 2010, approximately $3,856,000 of the loss was due to the impact of changes to the fair value of warrants under accounting rules.

Research and development (“R&D”) expenses increased about $145,000, or 112%, to $275,000 for the three months ended June 30, 2010 from approximately $130,000 for the three months ended June 30, 2009.  R&D expenses were higher during the three months ended June 30, 2010 versus June 30, 2009 due to an increase in Lung ARS related research activities.  Preclinical fees increased about $52,000 over the comparable period in 2009 due to increased animal study activity to support the Company’s ARS development program.  The Company currently has eight studies in progress: the study of its drug candidates as a potential countermeasure against the effects of sulfur mustard gas on the lung and skin, as a protectant against the effects of radiation on the lungs and on the gastro-intestinal tract, as a countermeasure against the effects of chlorine gas, as a potential treatment for epilepsy and for the potential treatment for Parkinson’s disease.

R&D expenses for our antioxidant program have totaled approximately $36,407,000 from inception through June 30, 2010. Because of the uncertainty of our research and development and clinical studies, we are unable to predict the level of spending and the anticipated program completion date, if any.

 

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General and administrative (“G&A”) expenses increased about $160,000, or 51%, to approximately $475,000 for the three months ended June 30, 2010 from approximately $315,000 for the three months ended June 30, 2009.  Salaries and wages increased by about $38,000 due to the hiring of a new employee during the first quarter of fiscal 2010.   Investor relations expenses increased by $48,000, due to increased IR-related activities performed by outside consultants, and legal fees increased by $43,000.

We incurred interest expense of approximately $17,000 for the three months ended June 30, 2010 compared to interest expense of about $114,000 for the three months ended June 30, 2009.  The decrease in interest expense is primarily the result of the conversion of a note payable to equity.

As disclosed previously, certain of the Company’s warrants to purchase common stock were deemed to be a liability upon adoption of a new accounting pronouncement on October 1, 2009.  Subsequent changes to the fair market value resulted in an offsetting charge on the statements of operations of about $3,856,000 for the three month period ended June 30, 2010.  The warrant liability and revaluations have not and will not have any impact on the Company’s working capital, liquidity, or business operations.

Nine months ended June 30, 2010 versus nine months ended June 30, 2009

We had a net loss of approximately $12,981,000 for the nine months ended June 30, 2010, versus a net loss of approximately $1,550,000 for the nine months ended June 30, 2009.   The loss for the first nine months of 2010 included $9,899,000 in non-cash charges for change in fair value of warrants.

Research and development (“R&D”) expenses increased by about $416,000, or 89%, to approximately $885,000 for the nine months ended June 30, 2010 from about $469,000 for the nine months ended June 30, 2010.  R&D expenses were higher during the nine months ended June 30, 2010 versus June 30, 2009 due to an increase in research activities to support the Company’s Lung ARS development program and the retention of a consultant to assist in the writing of proposals for government funding described in the discussion of three months results.  For the nine months ended June 30, 2010, consultant expenses increased by about $186,000 due to costs associated with the aforementioned consultant.  Preclinical fees increased about $187,000 over the comparable period in 2009 due to increased animal studies to support the Company’s ARS development program.  The Company currently has eight studies in progress: the study of its drug candidates as a potential countermeasure against the effects of sulfur mustard gas on the lung and skin, as a protestant against the effects of radiation on the lungs and on the gastro-intestinal tract, as a countermeasure against the effects of chlorine gas, as a potential treatment for epilepsy and for the potential treatment for Parkinson’s disease.

General and administrative (“G&A”) expenses increased approximately $434,000, or 48%, to approximately $1,337,000 for the nine months ended June 30, 2010 from about $903,000 for the nine months ended June 30, 2009.  Salaries and wages increased by about $100,000 due to the hiring of a new employee during the first quarter of fiscal 2010.  Consulting stock expense increased by about $207,000 as a result of a higher level of grant activity to employees, consultants, and directors.  Investor relations expenses increased by $80,000, due to increased IR-related activities performed by outside consultants, and legal fees increased by $87,000.

We incurred interest expense of approximately $860,000 for the nine months ended June 30, 2010 compared to interest expense of about $322,000 for the nine months ended June 30, 2009.  The expense in the nine month period ended June 30, 2010 reflects about $826,000 incurred in the first quarter of fiscal year 2010, mostly due to charges as a result of the conversion of the Senior Convertible Notes on October 6, 2009.  In the second and third quarters of 2010, interest expense dropped significantly principally due to the conversion of the aforementioned note payable to equity (and the recognition of the related non-legal fees in the first quarter).

As previously disclosed, certain of the Company’s warrants to purchase common stock were deemed to be a liability upon adoption of a new accounting pronouncement on October 1, 2009.  Subsequent changes to the fair market value resulted in an offsetting charge on the statements of operations of about $9,899,000 for the nine month period ended June 30, 2010.  The warrant liability and revaluations have not and will not have any impact on the Company’s working capital, liquidity, or business operations.

Liquidity and Capital Resources

We do not have any revenue and therefore we rely on investors, grants, collaborations and licensing of our compounds to finance our operations. At June 30, 2010, we had approximately $457,000 of cash and cash equivalents, a decrease of $189,000 from September 30, 2009. The decrease in cash was primarily due to the funding of expenses from operations, which was more than the $1.6 million in net proceeds from the October 2009 Financing.  We believe we have adequate financial resources to conduct operations into the first quarter of fiscal year 2012, but in order to fund on-going operating cash requirements beyond that point, or to further accelerate or expand our programs, we need to raise significant additional funds (see Subsequent Events).

 

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We incurred significant losses from operations of approximately $2,222,000 and $1,372,000, and cash outflows from operations of approximately $1,795,000 and $1,390,000, for the nine months ended June 30, 2010 and for the nine months ended June 30, 2009, respectively. Our ongoing future cash requirements will depend on numerous factors, particularly the progress of our catalytic antioxidant program and clinical trials and our ability to negotiate and complete collaborative agreements or out-licensing arrangements. In order to help fund our on-going operating cash requirements, we intend to seek new collaborations for our antioxidant research program that include initial cash payments and on-going research support. In addition, we might sell additional shares of our stock and/or convertible debentures and explore other strategic and financial alternatives, including a merger with another company, the sale of stock and/or debt, the establishment of new collaborations for current research programs, that include initial cash payments and ongoing research support and the out-licensing of our compounds for development by a third party.

There are significant uncertainties as to our ability to access potential sources of capital. We may not be able to enter into any collaboration on terms acceptable to us, or at all, due to conditions in the pharmaceutical industry or in the economy in general or based on the prospects of our catalytic antioxidant program. Even if we are successful in obtaining collaboration for our antioxidant program, we may have to relinquish rights to technologies, product candidates or markets that we might otherwise develop ourselves. These same risks apply to any attempt to out-license our compounds.

Similarly, due to market conditions, the illiquid nature of our stock and other possible limitations on equity offerings, we may not be able to sell additional securities or raise other funds on terms acceptable to us, if at all. Any additional equity financing, if available, would likely result in substantial dilution to existing stockholders.

Our forecast of the period of time through which our financial resources will be adequate to support our operations is forward-looking information, and actual results could vary.

Off-Balance Sheet Commitments

We do not have any off-balance sheet arrangements that have or are reasonably likely to have a current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.

ITEM 3. Quantitative and Qualitative Disclosures About Market Risk.

Our exposure to market risk is presently limited to the interest rate sensitivity of our cash and cash equivalents, which is affected by changes in the general level of U.S. interest rates. However, we believe that we are not subject to any material market risk exposure and do not expect that changes in interest rates would have a material effect upon our financial position. A hypothetical 10% change in interest rates would not have a material effect on our Statement of Operations or Cash Flows for the nine months ended June 30, 2010. We do not have any foreign currency or other derivative financial instruments. Our debt bears interest at a fixed rate.

ITEM 4. Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

As defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934 as amended, our management is responsible for establishing and maintaining adequate internal control over financial reporting. Internal control over financial reporting is a process designed by, or under the supervision of, our principal executive and principal financial officer and effected by our board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

Management’s Report on Internal Control over Financial Reporting

As required by Securities and Exchange Commission Rule 13a-15(b), we carried out an evaluation, under the supervision and with the participation of management, including our Chief Executive Officer and Chief Financial Officer.  Our management assessed the effectiveness of our internal control over financial reporting as of June 30, 2010. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control-Integrated Framework. Based upon its assessment, management concluded that, as of June 30, 2010, our internal control over financial reporting was not effective due to a material weakness existing with respect to the segregation of duties.

A “material weakness,” as defined by the Standards of the Public Company Accounting Oversight Board (PCAOB) is a deficiency, or a combination of deficiencies, in internal control over financial reporting, such that there is a reasonable possibility that a material misstatement of the Company’s annual or interim financial statements will not be prevented or detected on a timely basis. This material weakness has not resulted in an adjustment or misstatements to the financial statements.

 

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Management has determined that given the Company’s size, level of operations and financial resources, it is not practicable for the Company to eliminate the segregation of controls weakness and therefore management has established mitigating controls to minimize the impact of the lack of segregation of duties.  To address this material weakness, the Company engaged an executive search firm to conduct a search for a full time Chief Financial Officer. The Company is continuing a search process for a new Chief Financial Officer and expects to hire a new Chief Financial Officer by the end of September 2010.  Additionally, our Audit Committee has taken an active role in reviewing and discussing the identified material weakness with our auditors and senior management. Our management and the Audit Committee will actively monitor the implementation and effectiveness of the remediation measures taken by our financial management.

Changes in Internal Control over Financial Reporting

   Except as noted above, there have been no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended) during the quarter ended June 30, 2010 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

PART II.  OTHER INFORMATION

ITEM 1. Legal Proceedings.

None.

ITEM 1A. Risk Factors.

None.

ITEM 2. Unregistered Sales of Equity Securities and Use of Proceeds.

None.

ITEM 3. Defaults Upon Senior Securities.

None.

 

ITEM 4. Removed and Reserved.

N/A.

ITEM 5. Other Information.

 

None.

ITEM 6. Exhibits

Exhibit #		Description
31.1		Certification of the Chief Executive Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a).
31.2		Certification of the Chief Financial Officer pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a).
32.1		Certification by the Chief Executive Officer and Chief Financial Officer pursuant to 18 U.S.C. §1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

	AEOLUS PHARMACEUTICALS, INC.
Date: August 13, 2010	By:	/s/ John L. McManus
		John L. McManus President and Chief Executive Officer (Principal Executive Officer) Chief Financial Officer, Treasurer and Secretary (Principal Financial and Accounting Officer)

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