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Article by DailyStocks_admin    (12-24-08 06:42 AM)

Filed with the SEC from Dec 11 to Dec 17:

Northstar Neuroscience (NSTR)
RA Capital Management wrote to NSTR, urging the company to make a distribution or dividend to stockholders "as soon as possible." RA Capital continues "to be shocked and frustrated by the complete lack of response" to a letter it sent in July. Although RA Capital acknowledges some steps Northstar has taken to reduce expenses, it reiterates "that now is not the time for half-measures." RA Capital intends to pursue its interests "aggressively, both for our benefit and hopefully for the benefit of all stockholders, including preserving our right to take legal action against you and the company." RA Capital currently holds 2,539,139 shares (9.71% of the total outstanding).

BUSINESS OVERVIEW

Overview

Northstar Neuroscience, Inc. is a development stage medical device company incorporated in the State of Washington on May 18, 1999 focused on developing and commercializing innovative neuromodulation therapies to restore function and quality of life for people suffering from neurological diseases and disorders. Our proprietary Renova™ Cortical Stimulation System is designed to deliver targeted electrical stimulation to the cortex, the outermost layer of the brain, in a process called cortical stimulation. We are currently studying applications of our cortical stimulation therapy for several neurological conditions including major depressive disorder and stroke motor recovery. Because the cortex controls many neurological functions, we believe our cortical stimulation therapy system has the potential to treat these and other neurological diseases and disorders.

Neuromodulation Market

The field of neuromodulation, defined as the application of electrical or pharmacological stimulation to the central, peripheral, or autonomic nervous system, has grown dramatically in recent years. According to industry sources, the worldwide market for neuromodulation devices grew to greater than $1.5 billion in 2006 and is growing at an annual rate in excess of 20%. FDA-approved and cleared neuromodulation devices are currently utilized to treat a range of indications, including chronic pain, epilepsy, essential tremor, Parkinson’s disease, hearing loss, and depression. These devices are implanted in the body and are used to stimulate different parts of the central nervous system, including the spinal cord, vagus nerve, and various structures of the brain. Clinical trials are being conducted by companies utilizing these and other methods of neuromodulation for additional applications, such as treatment of obesity, hypertension, migraine headaches, and obsessive-compulsive disorder.

Our Renova Cortical Stimulation System Solution

Our Renova Cortical Stimulation System delivers targeted electrical stimulation to specific areas of the cortex. Because the cortex controls or influences many neurological functions, including neuropsychological functions, movement, hearing, and speech, cortical stimulation therapy has the potential to treat a variety of neurological diseases and disorders. We are evaluating our system for use in treating depression, stroke related upper-extremity hemiparesis, and tinnitus, which are disabling neurological disorders that afflict large numbers of patients. Because the cortex can be surgically accessed more easily than deeper brain structures, a neurosurgeon can implant our Renova Cortical Stimulation System in a relatively simple one- to two-hour surgical procedure. To date, we have treated over 100 patients with our system with a favorable safety profile.

The Renova Cortical Stimulation System is comprised of the following primary components:


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Implantable pulse generator, or IPG —an electrical stimulator that is implanted in the upper chest area just beneath the skin and provides the stimulation and power source for our therapy.


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Cortical stimulation lead —an electrode that connects to the IPG and delivers stimulation to the cortex. The electrode is placed either epidurally, on top of the dura, which is the tough membrane that covers the brain’s surface, or subdurally, just under the dura.


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Programming system —an external device that communicates with the IPG. The programming system allows the clinician to turn the IPG on/off and to set/modify stimulation parameters.

The methods of identifying the target area of the cortex for stimulation vary by indication. After identifying the target area of the cortex to stimulate, our cortical stimulation lead is implanted and connected to the IPG. Cortical stimulation is then provided under the direction of a treating medical professional.

Our Business Strategy

Our goal is to become a leading provider of neurostimulation solutions for patients who suffer from neurological diseases and disorders by establishing our Renova Cortical Stimulation System as the treatment of choice for multiple neurological indications. The key elements of the business strategy by which we intend to achieve these goals include:


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Evaluating our cortical stimulation therapy to treat specific neurological diseases and disorders, including depression and hand/arm impairment from stroke. To accomplish these goals, we plan to increase our focus on our cortical stimulation therapy for the treatment of depression, while also conducting targeted research on stroke motor recovery.


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Leveraging our technology platform to pursue additional neurological applications. We believe that cortical stimulation therapy has the potential to become an effective treatment for a variety of other neurological diseases and disorders. We are currently conducting targeted research to evaluate our cortical stimulation technology platform for other indications and may initiate additional clinical trials for these therapies.


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Expanding and strengthening our intellectual property position. We believe our cortical stimulation therapy system represents a novel, proprietary neurostimulation technology. We believe that our patents and patent applications broadly cover certain uses of cortical stimulation therapy in the treatment of neurological diseases and disorders. We intend to further pursue intellectual property protection through United States and foreign patent applications.


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Communicating the benefits of cortical stimulation therapy by publicizing clinical results obtained by leading clinicians. Although neuromodulation is a widely recognized and approved method for treating various neurological diseases and disorders, the field of cortical stimulation is an emerging treatment modality. As a result, we believe it will be important to increase awareness of our Renova Cortical Stimulation System, and cortical stimulation therapy in general, by continuing to generate strong clinical and scientific data through collaborations with key opinion leaders at leading academic and medical institutions.


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Commercializing our Renova Cortical Stimulation System. We intend to substantiate the benefits afforded by cortical stimulation by completing the necessary clinical studies to pursue regulatory approval. If regulatory approval is obtained, we will commercialize our Renova system to treat one or more neurological indications.

Potential Therapeutic Applications

Depression

Overview

Major depressive disorder, also commonly referred to as clinical depression or broadly as depression, is the most common of all psychiatric disorders and has a profound impact on the quality of life and activities of daily living for individuals and families. The economic impact of depression is significant. The total economic burden of depression in the U.S. in 2000 was more than $83 billion annually, of which $26 billion were direct treatment costs. Published research indicates that approximately 7% of U.S. adults, or about 15 million people, suffered from major depressive disorder. Traditionally, major depressive disorder has been treated with medication and short-term psychotherapies. The National Institute of Mental Health-sponsored STAR*D study concluded that 33% of people treated for major depressive disorder suffered from treatment resistant depression, or TRD meaning that they had failed four or more therapies. The results of these studies suggest that at least 4.0 to 5.0 million people in the U.S. suffer from treatment resistant depression. For these millions of patients suffering from TRD, neuromodulation may offer the potential for an effective therapy.

Existing Treatments

There are a number of neuromodulation therapies currently marketed or under investigation for depression, including those pursued by Cyberonics, Medtronic, Neuronetics, and St. Jude Medical. Neuromodulation therapies offered or being evaluated include electroconvulsive therapy, or ECT, vagus nerve stimulation, or VNS, deep brain stimulation, or DBS, and repetitive transcranial magnetic stimulation, or rTMS. While these therapies offer varying degrees of efficacy, some involve highly invasive surgical procedures, have a high incidence of serious side effects, provide only temporary results, or yield low efficacy rates. ECT and VNS are currently the only neuromodulation therapies cleared or approved by the FDA for the treatment of depression.

Our Therapy and Trial Results

We are currently investigating cortical stimulation therapy for TRD using our Renova system. We have focused our cortical stimulation therapy on the dorsolateral prefrontal cortex, which is an area of the cortex involved with reasoning and emotion, among other functions. There is clinical evidence suggesting that targeted stimulation of certain areas within the dorsolateral prefrontal cortex, using specific stimulation parameters, may help treat major depressive disorder. Previously published studies stimulating the dorsolateral prefrontal cortex using rTMS have demonstrated antidepressant effects in the treatment of depression. Although some patients with major depressive disorder benefit from rTMS, this form of therapy requires multiple sessions during the initiation phase, which typically lasts several weeks. Moreover, the effects of rTMS seem to be temporary, typically lasting only days to months, and require repeat applications.

The PROSPECT study is our ongoing feasibility trial evaluating cortical stimulation therapy in 12 patients with treatment resistant depression. In the PROSPECT study, all patients were implanted with our Renova Cortical Stimulation System. After a baseline observation period, half of the patients were randomized to receive active cortical stimulation during the first eight weeks of stimulation, while the other half of the patients were randomized to receive sham stimulation. After the initial eight-week period, the sham stimulation group began the same course of active stimulation provided to the other patients. The PROSPECT study evaluated improvements in patients’ condition using standard outcome measures: the Hamilton Depression Rating Scale, or HDRS, and the Montgomery-Asberg Depression Rating Scale, or MADRS, both of which measure the severity of depression, and the Global Assessment of Functioning, or GAF, which evaluates social, occupational, and psychological functioning to assess quality of life and ability to function.

The patients enrolled in the PROSPECT trial suffer from severe depression, having failed an average of nine previous therapies and endured their most recent depressive episode for an average of seven years. In addition, ten of the patients in the study were previously treated with ECT. We believe the patients in our PROSPECT trial represent a severe depression population.

Initial results from the PROSPECT study patients have been encouraging. Over the initial eight-week sham controlled phase of the study, Hamilton Depression Rating Scale scores of the active cortical stimulation patients improved an average of 21% from baseline, compared to only a 3% improvement from baseline in the sham group. After 16 weeks of active stimulation for patients in both groups, HDRS scores improved by an average of 24% from baseline. MADRS scores improved by an average of 29% from baseline. Furthermore, the GAF improved by an average of 41% from baseline.

Analysis of PROSPECT results has provided direction regarding further optimization of our cortical stimulation therapy for treatment resistant depression. Based on the encouraging results from our PROSPECT trial, as well as the significant market opportunity, we have initiated planning for additional clinical work for this indication.

Clinical Trials

Clinical trials for a new device that may pose a “significant risk,” such as our Renova Cortical Stimulation System, require submission of an application for an investigational device exemption, or IDE, to the FDA. The IDE application must be supported by appropriate data, such as animal and laboratory testing results, showing that it is safe to test the device in humans and that the testing protocol is scientifically sound. Clinical trials for an investigational device may begin once the IDE application is approved by the FDA and the institutional review boards, or IRBs, overseeing the clinical trial at the various investigational sites. We have obtained all such required approvals for all of our ongoing clinical trials prior to enrolling patients at our investigational sites. Clinical trials require extensive record keeping and reporting. Our clinical trials must be conducted under the oversight of an IRB at the relevant clinical trial site and in accordance with applicable regulations and policies including, but not limited to, good clinical practice, or GCP, requirements. We, the FDA, or the institutional review board at each site at which a clinical trial is being performed may suspend a clinical trial at any time for various reasons, including a belief that the risks to study patients outweigh the anticipated benefits.

Premarket Approval

Our Renova system is anticipated to be categorized as a class III medical device. FDA approval of a premarket approval application, or PMA, is required before marketing of most new class III medical devices in the United States. The process of obtaining premarket approval is costly, lengthy and uncertain. A PMA must be supported by extensive data including, but not limited to, technical, preclinical, and clinical trials to demonstrate to the FDA’s satisfaction the safety and effectiveness of the device. Among other information, the PMA must also contain a full description of the device and its components, a full description of the methods, facilities and controls used for manufacturing, and proposed device labeling.

If the FDA determines that a PMA is complete, the FDA files the application and begins an in-depth review of the submitted information. The FDA, by statute and regulation, has 180 days to review an application and provide a response, although the review and response activities generally occur over a significantly longer period of time, typically one year, and can take up to several years. During this review period, the FDA may request additional information or clarification of information already provided. During the review period, an advisory panel of experts from outside the FDA may be convened to review and evaluate the application and provide recommendations to the FDA as to the approvability of the device. Because there is no FDA-approved cortical stimulation device on the market, a review panel may be convened as part of any FDA review of our Renova Cortical Stimulation System. In addition, the FDA will conduct a preapproval inspection of our and our suppliers’ facilities to evaluate compliance with quality system regulations. The FDA will also conduct inspection of our records and our trial sites’ clinical records under the Bioresearch Monitoring inspection program. Under the Medical Device User Fee and Modernization Act of 2002, a fee to submit a PMA is generally applied, but certain companies, like Northstar Neuroscience, may qualify for a reduced fee for small businesses. New PMAs or PMA supplements are required for modifications to the manufacturing process, labeling, use, and design of a device.

Pervasive and Continuing FDA Regulation

Both before and after FDA approval, numerous regulatory requirements apply. These include:


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quality system regulation, which requires manufacturers to follow design, testing, control, documentation, and other quality assurance procedures during the design and manufacturing processes and into commercialization;


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regulations which govern product labels and labeling, prohibit the promotion of products for unapproved or “off-label” uses and impose other restrictions on labeling and promotional activities;


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medical device reporting regulations, which require that manufacturers report to the FDA if their device may have caused or contributed to a death or serious injury or malfunctioned in a way that would likely cause or contribute to a death or serious injury if it were to recur; and •

notices of correction or removal and recall regulations.

Advertising and promotion of medical devices are also regulated by the Federal Trade Commission and by state regulatory and enforcement authorities. Some promotional activities for FDA-regulated products have in the past resulted in enforcement actions brought under healthcare reimbursement laws and consumer protection statutes. In addition, under the federal Lanham Act, competitors and others can initiate litigation relating to advertising claims.

International

International sales of medical devices are subject to foreign government regulations, which vary substantially from country to country. The time required to obtain approval by a foreign country may be longer or shorter than that required for FDA approval, and the requirements may differ.

The primary regulatory environment in Europe is that of the European Community, or EC, which consists of 27 countries encompassing nearly all the major countries in Europe. The EC has adopted directives for active implantable medical devices and numerous standards that govern and harmonize the national laws and standards regulating a company’s quality system and the device design, manufacture, clinical trials, labeling, and adverse event reporting for medical devices that are marketed in member states. Medical devices that comply with the requirements of the national law of the member state in which they are first marketed will be entitled to affix the CE mark, indicating that the device conforms to applicable regulatory requirements, and, accordingly, can be commercially marketed within EC states and other countries that recognize this mark for regulatory purposes.

The method of assessing conformity with applicable regulatory requirements varies depending on the class of the device, but for our Renova Cortical Stimulation System (which falls into a class III category), the method involves a combination of a design dossier review of the safety and performance of the device, and an assessment of the manufacturer’s quality system by a third party Notified Body. A Notified Body is a private commercial entity that is designated by the national government of a member state as being competent to make independent judgments about whether a product complies with applicable regulatory requirements.

Research and Development

Our research and development expenses were approximately $19.4 million in 2007, $18.3 million in 2006, and $11.8 million in 2005. We expect our research and development expenditures to decrease in 2008, relative to 2007, as we are not planning to conduct a large-scale pivotal trial in 2008.

Employees

As of December 31, 2007, we had 84 employees. Approximately 62 employees were engaged in research and development and 22 in marketing, finance and other administrative functions. None of our employees is represented by a labor union or is covered by a collective bargaining agreement. We believe that we maintain good relations with our employees.

On January 22, 2008 we announced that our EVEREST pivotal clinical trial evaluating cortical stimulation for the treatment of hand and arm impairment following a stroke failed to meet its primary endpoint. Subsequently, on February 15, 2008, we implemented a reduction in our workforce including 19 employees, leaving 58 employees. We took this action to reduce operating costs and align operations with our strategic and clinical research plan.

CEO BACKGROUND

Class I Director Nominees

Carol D. Winslow. Ms. Winslow has been a director since March 2002. Since 2001, Ms. Winslow has been a principal of Channel Medical Partners, L.P., concentrating on medical technology investments. Ms. Winslow holds an A.B. from Mount Holyoke College and an M.B.A. from the University of Minnesota.

Michael D. Ellwein. Mr. Ellwein is currently an attorney with the law firm of Fredrikson & Byron and a venture partner with Three Arch Partners. Previously, Mr. Ellwein held several high-level positions during a seventeen-year career at Medtronic, Inc., where he was the Vice President and Chief Development Officer from 1998 to 2007, Vice President of Corporate Development and Associate General Counsel from 1993 to 1998, and Vice President of Corporate Development and Assistant General Counsel from 1990 to 1993. Mr. Ellwein holds a B.S. in Chemical Engineering from the South Dakota School of Mines and Technology, a J.D. from the University of Iowa, and has been admitted to the Iowa, Minnesota, and Ohio State Bar Associations.

Class II Directors Continuing in Office until the 2008 Annual Meeting of Shareholders

Wende S. Hutton. Ms. Hutton has been a director since May 1999. Since 2004, Ms. Hutton has been a venture partner at Canaan Partners. From 2001 to 2004, Ms. Hutton was a general partner of Spring Ridge Ventures, and from 1993 to 2001, she was a Managing Director of Mayfield Fund. Ms. Hutton holds a B.A. in Human Biology from Stanford University and an M.B.A. from Harvard University.

Robert E. McNamara. Mr. McNamara has been a director since May 2006. Since December 2004, Mr. McNamara has served as Senior Vice President and Chief Financial Officer at Accuray, Inc., a medical device company. From March 2003 to June 2004, Mr. McNamara served as Chief Executive Officer at InDefense, Inc., a security software company that was acquired by Microsoft, Inc. From March 2001 to August 2002, Mr. McNamara served as Senior Vice President and Chief Financial Officer at Recourse Technologies, Inc., a security software company that was acquired by Symantec Corporation. Mr. McNamara holds a B.A. in Accounting from the University of San Francisco and an M.B.A. from the Wharton School, University of Pennsylvania.

Dale A. Spencer. Mr. Spencer has been a director since August 1999. Since 1999, Mr. Spencer has been a private investor, primarily in the medical device industry. From 1995 to 1999, Mr. Spencer served as a director of Boston Scientific Corporation, a medical device company. From 1995 to 1997, Mr. Spencer served as Executive Vice President in the Office of the Chairman for Boston Scientific Corporation. Mr. Spencer serves as a director of ev3 Inc. Mr. Spencer holds a B.S. in Engineering from the University of Maine and an M.B.A. from University of Illinois.

Class III Directors Continuing in Office until the 2009 Annual Meeting of Shareholders

Alan J. Levy, Ph.D. Dr. Levy co-founded Northstar in 1999, and has been our President and Chief Executive Officer and a director since inception. From 1993 to 1998, Dr. Levy served as President and Chief Executive Officer of Heartstream, Inc., a medical device company that was acquired by Hewlett-Packard in 1998. From 1989 to 1993, Dr. Levy served as President and Chief Operating Officer of Heart Technology Inc., a medical device company that was acquired by Boston Scientific Corporation. Dr. Levy serves as a director of Intuitive Surgical, Inc. Dr. Levy holds a B.S. in Chemistry from City University of New York and a Ph.D. in Organic Chemistry from Purdue University.

Susan K. Barnes. Ms. Barnes has been a director since February 2006. From May 1997 to November 2005, Ms. Barnes served as Chief Financial Officer at Intuitive Surgical, Inc. Ms. Barnes holds an A.B. from Bryn Mawr College and an M.B.A. from the Wharton School, University of Pennsylvania.

Albert J. Graf. Mr. Graf has been a director since May 2006. Since October 2005, Mr. Graf has been a venture partner with New Enterprise Associates focusing on the medical device industry. From June 2000 to December 2004, Mr. Graf served as Group Chairman at Guidant Corporation, a medical device company. Mr. Graf serves as a director of American Medical Systems Holdings, Inc. Mr. Graf holds a B.S. in Economics from Boston University and an M.B.A. from Indiana University.

MANAGEMENT DISCUSSION FROM LATEST 10K
The following discussion and analysis should be read in conjunction with our audited financial statements and notes thereto that appear elsewhere in this report. This discussion contains forward-looking statements reflecting our current expectations that involve risks and uncertainties. Actual results may differ materially from those discussed in these forward-looking statements due to a number of factors, including those set forth in the section entitled “Risk Factors” and elsewhere in this report.

The statements contained in this Annual Report on Form 10-K, including statements under this section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements regarding our or our management’s expectations, hopes, beliefs, intentions or strategies regarding the future. The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan,” and similar expressions may identify forward-looking statements, but the absence of these words does not mean that a statement is not forward-looking. The forward-looking statements contained in this Annual Report on Form 10-K are based on our current expectations and beliefs concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we have anticipated. These forward-looking statements involve a number of risks, uncertainties or other assumptions that may cause actual results or performance to be materially different from those expressed or implied by these forward-looking statements. These risks and uncertainties include those factors described in greater detail in Item IA of Part I, “Risk Factors.” Should one or more of these risks or uncertainties materialize, or should any of our assumptions prove incorrect, actual results may vary in material respects from those anticipated in these forward-looking statements. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events or otherwise, except as may be required under applicable securities laws.

Overview

Management’s discussion and analysis provides additional insight into Northstar Neuroscience, Inc. and is provided as a supplement to, and should be read in conjunction with, our audited financial statements and accompanying footnotes thereto.

We are a development stage medical device company focused on developing and commercializing innovative neurostimulation therapies to restore function and quality of life for people suffering from neurological diseases and disorders. We incorporated in the State of Washington on May 18, 1999, and since inception we have devoted substantially all of our resources to the development and commercialization of medical technologies utilizing electrical stimulation to treat neurological diseases and disorders.

We are currently conducting, or plan to initiate, clinical trials using our proprietary Renova™ Cortical Stimulation System for the treatment of major depressive disorder and stroke motor recovery. We continue to explore additional applications for our cortical stimulation platform and monitor relevant research activities on other neurological diseases and disorders. We have completed enrollment and are actively treating patients in our PROSPECT trial, which is our initial feasibility trial using cortical stimulation to treat major depressive disorder and in our SAHALE feasibility trial for tinnitus. We also have completed enrolling patients in the EVEREST pivotal trial for stroke motor recovery and announced the primary endpoint data in January of 2008.

From 2004 to 2007, we conducted the EVEREST pivotal trial to investigate whether cortical stimulation in conjunction with rehabilitation therapy would lead to improved hand and arm function and activities of daily living compared to the control group which received rehabilitation therapy alone. On January 22, 2008, we announced that the EVEREST trial did not meet its primary efficacy endpoint and we do not expect ongoing or subsequent analysis, once completed, will demonstrate sufficient evidence of efficacy to pursue marketing approval from the FDA based on EVEREST data alone. We have commenced planning next steps, including additional clinical work and an analysis of the business opportunity for a potentially optimized therapy for stroke motor recovery.

On February 15, 2008, we announced and began implementing restructuring actions with the objective of streamlining our business in response to the announcement of the results of the EVEREST trial. The restructuring actions include a workforce reduction of approximately 32%. We intend to focus our ongoing resources on the evaluation and development of our Renova Cortical Stimulation System for the treatment of major depressive disorder, while also pursuing focused research on stroke motor recovery. We will continue to conduct research on the feasibility of our system for the treatment of other neurological diseases and disorders consistent with our financial and operational resources.

To date, we have not generated any revenue from the sale of cortical stimulation products, and we have incurred net losses in each year since our inception. The limited revenue we have generated since inception has been from the commercial sale of an earlier product, which was sold to a third party in 2003. We expect our net losses to continue, though at a reduced magnitude relative to recent losses, as we continue our clinical trial activities, our research and development efforts, and continue to operate as a public held company. To date, we have financed our operations primarily through public and private placements of equity securities.

Critical Accounting Policies and Significant Judgments and Estimates

Our 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 financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate estimates, including, but not limited to those related to share-based compensation and clinical trial accruals. We base our estimates on historical experience and on other factors that we believe are reasonable under the circumstances, the results of which 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 materially from these estimates under different assumptions or conditions.

Our significant accounting policies are described in Note 1 to our audited financial statements for the year ended December 31, 2007. We believe that the following accounting policies relating to research, development and clinical trial accruals and share-based compensation are the most critical to understanding and evaluating our reported financial results.

Research, Development and Clinical Trial Accruals

Research and development costs are expensed as incurred or paid. We record accruals for estimated clinical trial costs, comprised primarily of services rendered under contract by our clinical trial sites, based on patient enrollment and progression through the clinical trial protocol. Clinical trial costs are a significant component of our research and development expenses.

Share-based Compensation Pursuant to SFAS 123(R)

Through December 31, 2005, we accounted for employee stock options using the intrinsic-value method in accordance with Accounting Principles Board Opinion No. 25, or APB 25, Accounting for Stock Issued to Employees , Financial Accounting Standards Board Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation an interpretation of APB 25, and related interpretations. We had adopted the disclosure-only provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation, or SFAS 123, as amended.

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123 (R), Share-Based Payment , or SFAS 123(R), which requires the recognition of share-based compensation expense at fair value. We adopted SFAS 123(R) under the prospective transition method and, therefore, we did not restate results for prior periods.

Pursuant to SFAS 123(R), our estimate of share-based compensation expense requires a number of complex and subjective assumptions including our stock price volatility, employee exercise patterns, and future forfeitures. The value of a stock option is derived from its potential for appreciation. The more volatile the stock, the more valuable the option becomes over its term because of the greater possibility of significant increases in stock price. We have determined the implied volatility of future periods based primarily on the historical volatility of our common stock subsequent to our initial public offering. The expected term of options granted represents the period of time that options granted are expected to remain outstanding. The expected term also has a significant effect on the value of the option. The longer the term, the more time the option holder has to allow the stock price to increase without a cash investment and thus, the more valuable the option. Further, longer option terms provide more opportunity to exploit market highs. Historical data, however, demonstrates that employees typically do not wait until the end of the contractual term of a nontransferable option to exercise. When establishing an estimate of the expected term of an award, we continue to use the simplified method of determining expected term as permitted by SEC Staff Accounting Bulletins 107 and 110, as we do not have sufficient exercise experience on which to base a determination of expected term. We review our valuation assumptions at each grant date and from time to time we will likely change the valuation assumptions used to estimate the value of future share-based awards granted.

Pursuant to Financial Accounting Standards Board Staff Position No. 123(R)-3, Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards , we have adopted the simplified method to calculate our additional paid-in-capital, or APIC, pool of excess tax benefit. This method was used to calculate our beginning APIC pool and to determine the subsequent effect on the APIC pool for stock-based compensation awards that were outstanding upon our adoption of SFAS 123(R).

Income Taxes

Effective January 1, 2007, we adopted the provisions of the Financial Accounting Standards Board, or FASB, Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an interpretation of FASB Statement No. 109 , or FIN 48. FIN 48 contains a two-step approach to recognizing and measuring uncertain tax positions accounted for in accordance with SFAS No. 109. The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than 50% likely of being realized upon ultimate settlement. We consider many factors when evaluating and estimating our tax positions and tax benefits, which may require periodic adjustments and which may not accurately anticipate actual outcomes. Based on the implementation guidance set forth in the pronouncement and our review of our tax positions leading up to and subsequent to adoption, FIN 48 did not have a material impact on our financial position, results of operations, or cash flows.

Recent Accounting Pronouncements

In September 2006, the Financial Accounting Standards Board, or FASB, issued SFAS No. 157, Fair Value Measurements, which defines fair value, establishes a framework for measuring fair value in accordance with generally accepted accounting principles and expands disclosures about fair value measurements. We adopted SFAS No. 157 on January 1, 2008, and we do not expect the adoption to have a material impact on our financial position, results of operations, or cash flows.

In February 2007, the FASB issued SFAS No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. SFAS No. 159 permits companies to choose to measure many financial instruments and certain other items at fair value. We adopted SFAS No. 159 on January 1, 2008, and we do not expect the adoption to have a material impact on our financial position, results of operations, or cash flows.

In June 2007, FASB’s Emerging Issues Task Force, or EITF reached a consensus on Issue No. 07-3, Accounting for Advance Payments for Goods or Services to Be Used in Future Research and Development Activities , or EITF 07-3. The consensus will require us to defer and capitalize prepaid, nonrefundable research and development payments to third parties over the period in which the research and development activities are performed or the services are provided, subject to an assessment of recoverability. EITF 07-3 is effective for fiscal years beginning after December 15, 2007 and early adoption is not permitted. Subsequent to our adoption of EITF 07-1 on January 1, 2008, a change in accounting policy will occur whereby nonrefundable prepayments for research and development services will be deferred and recognized as the services are rendered. Under our existing accounting policy such payments are charged to research and development expense as paid. This accounting policy change may impact our financial condition and the results of operations in the future.

Results of Operations for the Years Ended December 31, 2007, 2006 and 2005

Research and Development Expenses

Our research and development expenses primarily consist of costs incurred to conduct clinical trials, engineering development costs associated with our Renova Cortical Stimulation System, and regulatory compliance activities. Research and development expenses are comprised of direct clinical trial costs, employee compensation, including share-based compensation, supplies and materials, consultant services, information technology support, travel, and facilities. We expensed research and development costs at the earlier of when they were incurred, or when they were paid and non-refundable. From our inception through December 31, 2007, we have incurred $84.8 million in research and development expenses.

Research and development expenses were $19.4 million in 2007, $18.3 million in 2006, and $11.8 million in 2005. The $1.1 million, or 6%, increase in 2007 was primarily due to increased compensation and benefits, including stock compensation, of $1.6 million for additional staffing to support clinical trials and planning for commercialization efforts associated with our Renova system. Greater expenses associated with commercialization efforts in 2007 can be attributed to prototypes of commercial product and expenses related to engineering consultants increasing in the aggregate by $1.2 million. The increases were partially offset by a reduction in clinical trial costs of $2.0 million, primarily due to the completion of the EVEREST clinical trial enrollment in 2007, and a net increase of other development expenses of $300,000.

The increase of $6.5 million, or 55%, in 2006 compared to 2005 was due to substantial increases in expenses related to the EVEREST clinical trial of $5.2 million and increased headcount-related expenses of $1.5 million, partially offset by a net decrease in other development costs of $200,000.

We expect our research and development expenses to decrease in 2008 principally due to lower overall clinical trial costs since we have no further pivotal trials scheduled for 2008. We also expect to experience decreases in activity associated with the commercialization efforts of the Renova system. Our research and development efforts will be focused on the treatment of depression, as well as research relating to the viability of treatment of other indications with our Renova Cortical Stimulation System.

Selling, General and Administrative Expenses

Our selling, general and administrative expenses include compensation for executive, finance, intellectual property, marketing and administrative personnel, including share-based compensation, and facilities expenses. Other significant expenses include professional fees for accounting and legal services, including legal services associated with our efforts to obtain and maintain protection for the intellectual property related to our cortical stimulation system. Selling, general and administrative expenses were $9.4 million in 2007, $6.2 million in 2006, and $3.3 million in 2005. The $3.2 million, or 52%, increase in 2007 compared to 2006 was primarily due to a $1.2 million increase in compensation and benefits, including stock compensation, for additional staffing to support operating as a publicly-held company, infrastructure development, and initial marketing efforts related to commercialization planning . The 2007 expenses also included a $1.2 million increase in professional services for accounting, investor relations, and legal services relating to public company matters and intellectual property, a $520,000 increase in consultant expenses related to reimbursement and IT infrastructure development, and a $320,000 net increase in other general and administrative expenses, primarily relating to insurance, recruiting, relocation and travel associated with increased personnel.

The increase of $2.9 million, or 88%, in 2006 over 2005 was primarily due to increased personnel costs of $1.2 million, increased professional service costs of $1.1 million for accounting, investor relations, legal services relating to public company matters and intellectual property, and net increases in other general and administrative expenses of $600,000, primarily relating to consultants, board of directors fees and expenses, insurance, market research and reimbursement planning.

We expect our selling, general and administrative expenses to decrease in 2008 due to a decrease in activity related to commercialization and marketing efforts associated with the stroke-motor recovery application of our system, and overall lower headcount-related costs as a result of our February 2008 reduction in force.

Other Operating Expenses

Since inception, other operating expenses have included severance expenses, losses on subleases of our facilities, and intellectual property settlements. No other operating expenses were incurred during 2007. During 2006 an expense of $2.5 million was incurred to settle a potential ownership dispute and secure ownership rights related to one of our issued U.S. patents and six of our U.S. patent applications. The settlement was expensed on the date incurred. In 2005, we had $794,000 of other operating expenses related to a loss on sublet office space.

Interest Income, Net

Interest income, net was $5.0 million in 2007, $3.3 million in 2006, and $558,000 in 2005. The increase of $1.7 million in 2007 over 2006 was due to interest earned on a higher average balance of investments over the full year. The increase of $2.7 million in 2006 over 2005 was due primarily to interest earned on the investment of proceeds received mid-year from our initial public offering.

Other (Expenses) Income, Net

Other (expenses) income, net included $1.4 million of expense in 2006, and income of $682,000 in 2005. The expense of $1.4 million in 2006 was due to losses incurred on debt repayment and non-cash warrant revaluation charges. The other income of $682,000 in 2005 represents amortization of a gain on assets sold in a prior year.

Liquidity and Capital Resources

We have incurred losses since our inception in May 1999 and, as of December 31, 2007, we had a deficit accumulated during the development stage of $118.3 million. As of December 31, 2007, we had $83.5 million in cash, cash equivalents and investments. We have funded our operations to date principally from the sale of equity securities, raising net proceeds of $192.7 million through December 31, 2007.

Net Cash Used in Operating Activities

Net cash used in operating activities in 2007, 2006, and 2005 primarily reflects the net loss for those periods, offset in part by non-cash operating expenses including share-based compensation, loss on debt repayment, depreciation, and amortization of premiums on investments, and changes in operating assets and liabilities.

Net Cash Provided by and Used in Investing Activities

Net cash provided by and used in investing activities in 2007, 2006, and 2005 primarily reflects the net of purchases and maturities of investments and purchases of fixed assets.

Net Cash Provided by Financing Activities

Net cash provided by financing activities during 2007 reflects the exercises of stock options. Net cash provided by financing activities in 2006 was primarily attributable to the net proceeds from our initial public offering of $112.0 million, offset by repayment of debt of approximately $7.0 million. Net cash provided by financing activities in 2005 was primarily from the issuance of debt.

Operating Capital and Capital Expenditure Requirements

To date, we have not commercialized any product based on our cortical stimulation technology and we have not achieved profitability. We anticipate that we will continue to incur substantial net losses for the next several years as we develop our products, conduct and complete clinical trials, pursue additional applications for our technology platform and expand our clinical development.

We do not anticipate generating any product revenue unless and until we successfully obtain FDA approval for, and begin selling, our Renova Cortical Stimulation System. We believe that our cash, cash equivalents, investments, and related interest income will be sufficient to meet our anticipated cash requirements into 2011. If our available cash, cash equivalents and investments are insufficient to satisfy our liquidity requirements, or if we develop additional products or pursue additional applications for our products, we may seek to sell additional equity or issue debt securities before 2011. The sale of additional equity securities may result in additional dilution to our shareholders. If we raise additional funds through the issuance of debt securities, these securities could have rights senior to those of our common stock and could contain covenants that would restrict our operations. We will require additional capital beyond our currently forecasted amounts. Any such required additional capital may not be available on reasonable terms, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of, delay, or eliminate some or all of, our planned research, development and commercialization activities, which could materially harm our business.

We anticipate spending additional funds over the next year for the development of new applications of our Renova system that may also require the expenditure of significant financial resources and take several years to complete, from development to ultimate commercialization. We expect to fund the development of applications for our Renova system with our existing cash, cash equivalents and investment balances.

Our forecast of the period of time through which our financial resources will be adequate to support our operations and the costs to complete development of products are forward-looking statements and involve risks and uncertainties, and actual results could vary materially and negatively as a result of a number of factors, including the factors discussed in the “Risk Factors” section of this Annual Report on Form 10-K. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect.

Because of the numerous risks and uncertainties associated with the development of medical devices, such as our Renova Cortical Stimulation System, we are unable to estimate the exact amounts of capital outlays and operating expenditures necessary to complete ongoing clinical trials and successfully deliver a commercial product to market. Our future funding requirements will depend on many factors, including but not limited to:


•

the scope, rate of progress, and cost of our clinical trials and other research and development activities;


•

clinical trial results;


•

the costs and timing of regulatory approvals;


•

the working capital required for general and administrative expenses;


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the cost and timing of establishing sales, marketing and distribution capabilities;


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the cost of establishing clinical and potential commercial supplies of our Renova Cortical Stimulation System and any other products that we may develop;


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the rate of market acceptance of our device;


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the effect of competing products and market developments;


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any revenue generated by sales of our future products;


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the cost of filing and prosecuting patent applications and defending and enforcing our patent and other intellectual property rights;


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the cost of defending, in litigation or otherwise, any claims that we infringe third party patent or other intellectual property rights;


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the cost of defending other litigation or disputes with third parties; and


•

the extent to which we acquire or invest in businesses, products, and technologies.


MANAGEMENT DISCUSSION FOR LATEST QUARTER

The statements contained in this Quarterly Report on Form 10-Q, including under this section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, without limitation, statements regarding our or our management’s expectations, hopes, beliefs, intentions, or strategies regarding the future. The words “believe,” “may,” “will,” “estimate,” “continue,” “anticipate,” “intend,” “expect,” “plan,” and similar expressions may identify forward-looking statements, but the absence of these words does not mean that a statement is not forward-looking. The forward-looking statements contained in this Quarterly Report on Form 10-Q are based on our current expectations and beliefs concerning future developments and their potential effects on us. There can be no assurance that future developments affecting us will be those that we have anticipated, or that the results of our engagement of a financial advisor, or our analysis of strategic alternatives will result in any transaction or arrangement with a third party. These forward-looking statements involve a number of risks, uncertainties, or other assumptions that may cause actual results or performance to be materially different from those expressed or implied by these forward-looking statements. These risks and uncertainties include those factors described in greater detail in Item 1A of Part II, “Risk Factors.” Should one or more of these risks or uncertainties materialize, or should any of our assumptions prove incorrect, actual results may vary in material respects from those anticipated in these forward-looking statements. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise, except as may be required under applicable securities laws.

Overview

Management’s discussion and analysis provides additional insight into Northstar Neuroscience, Inc. and is provided as a supplement to, and should be read in conjunction with, our audited financial statements and accompanying footnotes thereto.

We are a development stage medical device company focused on developing innovative neuromodulation therapies to restore function and quality of life for people suffering from depression. We incorporated in the State of Washington on May 18, 1999 and since inception we have devoted substantially all of our resources to the development and commercialization of medical technologies utilizing electrical stimulation to treat neurological diseases and disorders.

To date, we have not generated any revenue from the sale of cortical stimulation products, and we have incurred net losses in each year since our inception. The limited revenue we generated since inception reflects the commercial sale of an earlier product, which was divested in 2003. We expect our net losses to continue, though at reduced levels relative to recent losses, as we continue our clinical trial activities, our research and development efforts, and continue to operate as a publicly held company. To date, we have financed our operations primarily through public and private placements of equity securities.

In October 2008 we announced that the U.S. Food and Drug Administration, or FDA, granted conditional approval of our second clinical study of our Renova™ Cortical Stimulation System for the treatment of major depressive disorder, our PROSPECT II trial. With this approval, we expect to begin enrolling patients into our PROSPECT II study in the fourth quarter of 2008, with results anticipated during the second half of 2009. The PROSPECT II study is a sham-controlled study building on the positive safety profile and promising efficacy observed in our PROSPECT I feasibility trial. The trial will be conducted at up to six investigational sites and will include up to 24 patients.

We are currently conducting clinical trials using our proprietary Renova™ Cortical Stimulation System for the treatment of major depressive disorder. We have completed enrollment and are actively treating patients in our PROSPECT I trial, which is our initial feasibility trial using cortical stimulation to treat major depressive disorder. In addition, we are continuing long-term follow up of patients in our SAHALE trial, our feasibility trial for tinnitus.

In response to the January 2008 results of our EVEREST pivotal trial, during the first quarter of 2008 we implemented a cost reduction plan that included the elimination of recurring and planned costs associated with our expected submission of a premarket approval application to the FDA and related anticipated commercial launch of our cortical stimulation system for stroke motor recovery, as well as modifications to our clinical and development programs and a 32% reduction in our workforce. In July 2008, we further revised our strategic plan by focusing our research and development efforts on our cortical stimulation therapy system for the treatment of depression and suspended activities for our other indications. Our revised plan led to an additional workforce reduction, and sublease of a portion of our headquarters facility. Expenses associated with the workforce reductions and sublease total $982,000 and $1.8 million for the three- and nine-month periods ending September 30, 2008, respectively. The $1.8 million expensed to date includes approximately $1.7 million related to employee termination benefits, including non-cash share-based compensation charges of approximately $260,000 related to acceleration of unvested equity awards, and other non-cash restructuring costs of $120,000 related to losses incurred on the sublease loss of our headquarters facility. Expenses for the nine-month period ending September 30, 2008 reflect total incurred costs related to the cost reduction plan of $1.2 million in research and development and $570,000 in general and administrative expenses. Additionally, as a result of our third quarter reduction in force, we expect to incur further charges of $130,000 related to termination benefits for employees who were impacted by our restructuring but had termination dates after September 30, 2008.

Critical Accounting Policies and Significant Judgments and Estimates

Our financial statements have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements as well as reported expenses during the reporting periods. We periodically evaluate our estimates, including, but not limited to those related to share-based compensation and clinical trial accruals. We base our estimates on historical experience and on other factors that we believe are reasonable under the circumstances, the results of which 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 materially from these estimates under different assumptions or conditions. Our critical accounting policies and estimates have not changed significantly from those policies and estimates disclosed under the heading “Critical Accounting Policies and Significant Judgments and Estimates” in our Form 10-K for the fiscal year ended December 31, 2007, filed with the Securities and Exchange Commission on March 17, 2008.

On January 1, 2008, we adopted SFAS 157, which enhances existing guidance for defining fair value for measuring assets and liabilities. SFAS 157 provides a single definition of fair value, together with a measurement framework, and requires additional disclosure about the use of fair value to measure assets and liabilities. The definition of fair value and framework for measuring it outlined in SFAS 157 does not have a material impact on our existing valuation methodology or disclosed values. Pursuant to the provisions of SFAS 157, we disclose information on all assets and liabilities reported at fair value that enables an assessment of the inputs used in determining the reported fair values. Our marketable cash equivalents and investment securities, classified as available for sale, are reported at fair value with changes in value recorded as a component of other comprehensive income. SFAS 157 establishes a fair value hierarchy that prioritizes valuation inputs based on the observable nature of those inputs. The SFAS 157 fair value hierarchy applies only to the valuation inputs used in determining the reported fair value of our investments and is not a measure of the investment credit quality. The hierarchy defines three levels of valuation inputs:



Level 1 inputs defined as quoted prices in active markets;

Level 2 inputs generally include inputs with other observable qualities, such as quoted prices in active markets for similar assets or quoted prices for identical assets in inactive markets; and

Level 3 inputs valuations based on unobservable inputs.

Management determines fair value of our investments with the assistance of our investment advisors and custodians who use industry accepted pricing services and financial models. The majority of our investments are valued using Level 2 valuation inputs. The valuations of investments using Level 2 inputs may differ from amounts realized by us in an actual transaction. We have the ability and intent to hold our investments to maturity and realize their stated par value. Therefore, we expect variations in valuations based on changing market conditions, methods used to determine valuations, and/or input assumptions to be temporary, as fair value will equal par value at maturity.

Financial Overview

Research and Development Expenses

Our research and development expenses consist primarily of costs incurred to conduct clinical trials, engineering development costs associated with our Renova Cortical Stimulation System, and regulatory compliance activities. These costs include direct clinical trial costs, employee compensation, including share-based compensation, supplies and materials, consultant services, information technology support, travel, and facilities. We expense research and development costs during the period in which they are incurred. In accordance with EITF No. 07-3, nonrefundable advance payments related to future research and development activities are deferred and recognized as expense in the period that the related goods are delivered or services are performed. From our inception through September 30, 2008, we have incurred $94.5 million in research and development expenses.

We expect our research and development expenses to decrease for the remainder of 2008, relative to prior periods, due to lower overall clinical trial costs as we have completed our EVEREST pivotal trial and anticipate lower overall patient enrollment activity in our ongoing clinical programs in 2008 as compared to 2007. We also expect to experience decreases in personnel-related costs and development costs associated with our revised strategic plan, which will focus our research efforts on development of our cortical stimulation therapy for the treatment of depression.

General and Administrative Expenses

Our general and administrative expenses primarily include compensation expenses, including share-based compensation, for executive, finance, intellectual property, and administrative personnel. Other significant expenses include facility costs and professional fees for accounting and legal services, including legal services associated with intellectual property.

We expect our general and administrative expenses to decrease for the remainder of 2008, relative to prior periods, due to the elimination of activity related to the commercialization and marketing efforts associated with our stroke motor recovery application, and overall lower personnel-related costs as a result of our lower headcount related to our 2008 workforce reductions.

Results of Operations

Three-month Periods Ended September 30, 2008 and 2007

Research and Development Expenses

Research and development expenses were $2.9 million for the three-month period ended September 30, 2008, compared to $4.4 million for the three-month period ended September 30, 2007. The decrease of $1.5 million, or 34%, was primarily due to a reduction in consulting costs of $420,000 and clinical trial costs of $380,000, both due to the completion of the EVEREST clinical trial enrollment in 2007. Additional decreases include a $380,000 reduction in product development expenses, a decrease of $250,000 in share-based compensation, and net decreases in other development expenses of $70,000.

General and Administrative Expenses

General and administrative expenses were $1.9 million for the three-month period ended September 30, 2008, compared to $2.2 million for the three-month period ended September 30, 2007. The decrease of $300,000, or 14%, was primarily due to decreases in share-based compensation expense of $470,000, and marketing-related expenses of $120,000. Increased corporate and intellectual property legal services of $250,000, and $40,000 of net increases in other administrative expenses, partially offset the decreases noted.

Interest Income, Net

Interest income, net, was $450,000 for the three-month period ended September 30, 2008, compared to $1.2 million for the three-month period ended September 30, 2007. The decrease of $750,000, or 63%, reflects reduced interest earned on cash and investments attributable primarily to lower average balances of our investment securities and decreased interest rates stemming from general market conditions. Interest income, net for the three-month period ended September 30, 2008 also included realized losses of $92,000 relating to other-than-temporary declines in the value of investment securities that were sold during the period and subsequently settled.

Nine-month Periods Ended September 30, 2008 and 2007

Research and Development Expenses

Research and development expenses were $9.7 million for the nine-month period ended September 30, 2008, compared to $15.9 million for the nine-month period ended September 30, 2007. The decrease of $6.2 million, or 39%, was primarily due to a reduction in clinical trial costs of $5.0 million, consulting related costs of $770,000, product development costs of $390,000, share-based compensation expense of $300,000, and net decreases in other development expenses of $380,000, due to the completion of the EVEREST clinical trial enrollment in 2007. These amounts were partially offset by a net increase of $640,000 for compensation and benefits primarily related to termination benefits resulting from our 2008 reductions in force.

General and Administrative Expenses

General and administrative expenses were $6.2 million for the nine-month period ended September 30, 2008 compared to $7.0 million for the nine-month period ended September 30, 2007. The decrease of $800,000, or 11%, was due to a $600,000 decrease in consulting, marketing and recruiting expenses, a $370,000 reduction for intellectual property related expenses, share-based compensation expense of $210,000 and net decreases of $110,000 in other administrative expenses due to reduced commercialization efforts. Increases of $150,000 for compensation and benefits primarily related to termination benefits resulting from our 2008 reductions in force as well as increases in corporate legal expenses of $350,000 partially offset the decreases noted.

Interest Income, Net

Interest income, net, was $2.0 million for the nine-month period ended September 30, 2008, compared to $3.9 million for the nine-month period ended September 30, 2007. The decrease of $1.9 million, or 49%, is attributable primarily to lower average balances of our investment securities and decreasing interest rates stemming from general market conditions. Interest income, net for the nine-month period ended September 30, 2008 also included realized losses of $92,000 relating to other-than-temporary declines in the value of investment securities that were sold during the period and subsequently settled.

Liquidity and Capital Resources

We have incurred losses since our inception in May 1999 and, as of September 30, 2008, we had a deficit accumulated during the development stage of $132.2 million. We have funded our operations to date from public and private placements of equity securities and stock option exercises, raising net proceeds of $192.8 million through September 30, 2008. As of September 30, 2008, we had $70.3 million in cash, cash equivalents, and investments.

Operating Capital and Capital Expenditure Requirements

To date, we have not commercialized any product based on our cortical stimulation technology and we have not achieved profitability. We anticipate that we will continue to incur substantial net losses for the next several years as we develop our products, conduct and complete clinical trials, and expand our clinical development.

We do not anticipate generating any product revenue unless and until we successfully obtain FDA approval for and begin selling, our Renova Cortical Stimulation System. Based on our current strategic plan, we believe that our cash, cash equivalents, investments, and related interest income will be sufficient to meet our anticipated cash requirements into 2012. If our available cash, cash equivalents, and investments are insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or issue debt securities. The sale of additional equity securities may result in additional dilution to our shareholders. If we raise additional funds through the issuance of debt securities, these securities could have rights senior to those of our common stock and could contain covenants that would restrict our operations. We will require additional capital beyond our currently forecasted amounts. Any such required additional capital may not be available on reasonable terms, if at all. If we are unable to obtain additional financing, we may be required to reduce the scope of, delay, or eliminate some or all of, our planned research and development, which could materially harm our business.

Our forecasts regarding our financial resources and the costs to complete development of products are forward-looking statements and involve risks and uncertainties, and actual results could vary materially and negatively as a result of a number of factors, including the factors discussed in the “Risk Factors” section and elsewhere in this Quarterly Report on Form 10-Q. We have based these estimates on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we currently expect.

Because of the numerous risks and uncertainties associated with the development of medical devices, such as our Renova Cortical Stimulation System, we are unable to estimate the exact amounts of capital outlays and operating expenditures necessary to complete ongoing clinical trials and successfully deliver a commercial product to market. Our future funding requirements will depend on many factors, including but not limited to:


•

the scope, rate of progress, and cost of our clinical trials and other research and development activities;


•

clinical trial results;


•

the costs and timing of regulatory approvals;


•

the working capital required for general and administrative expenses;


•

the cost and timing of establishing sales, marketing and distribution capabilities;


•

the cost of establishing clinical and potential commercial supplies of our Renova Cortical Stimulation System and any other products that we may develop;


•

the rate of market acceptance of our device;


•

the effect of competing products and market developments;


•

any revenue generated by sales of our future products;


•

the cost of filing and prosecuting patent applications and defending and enforcing our patent and other intellectual property rights;


•

the cost of defending, in litigation or otherwise, any claims that we infringe third party patent or other intellectual property rights;


•

the cost of defending other litigation or disputes with third parties; and


•

the extent to which we acquire or invest in businesses, products, and technologies.

CONF CALL


John Bowers

Thank you. On today's call, Ray and I will provide you with an update on our clinical program for depression and review our financial results and guidance. We'll also be discussing our future strategic direction, including an update of the review process being conducted by Northstar and our Board of Directors.

Before I begin, I'd like to comment on the recent public dialogue with certain of our shareholders. As you may know, we've been publicly contacted by certain shareholders who have either offered to enter into negotiations to purchase the company at a significant discount to cash value or who have suggested an immediate liquidation of the company. We value the input of all our shareholders and take their points of view and suggestions seriously. We remain committed to exploring all options to enhance long-term shareholder value for all shareholders of Northstar.

Since our EVEREST trial data was announced in January, our management team and our Board of Directors have engaged in a comprehensive process to determine how to prove best to prudently utilize the company's resources to accomplish this goal. Before I comment on our recent changes, I'd like to review what we've accomplished since our initial EVEREST pivotal trial primary end point data was released.

In February, we took steps to conserve capital that included a reduction in force and other cost cutting measures. Subsequently, we completed the full analysis of the extensive EVEREST data, including subset analyses to fully understand the implications of the trial results and to evaluate the potential that cortical stimulation has to restore hand and arm function in stroke patients.

We also performed additional long-term analysis of the data from our depression study, PROSPECT, indicating that improvements in patient depression symptoms appear to improve over time. The results of our EVEREST data review and our analysis of the long-term depression data from PROSPECT were both completed during the second quarter and shared in June at the American Association of Stereotactic and Functional Neurosurgery meeting.

More recently, management and the Board have continued our strategic review of our clinical program. As a result, we made additional decisions about our business. Most notably, we made the difficult decision to put our stroke program on hold. We continue to be encouraged by the subset analysis of the EVEREST data and believe that our cortical stimulation therapy retains promise to provide meaningful improvements for stroke patients with hand and arm impairment.

We also believe that there is a path to confirm that clinically with a refined treatment protocol. Despite this, we believe that our most prudent strategic course is to focus solely on depression in the near-term. We are considering alternative means to progress our technology to stroke motor recovery and our other clinical indications while we focus on depression.

In addition, we announced today the implementation of further cost reductions designed to better align our organization and cost structure with our singular focus on depression. These reductions include, among others, further reductions in our workforce and sublease of approximately 40% of our office space. As Ray will more fully outline, taken into account our focus on depression and other cost reduction efforts, we expect that our net use of cash for the remaining two quarters of 2008, including the cost of our July reduction in force, will be approximately $8 million and anticipate net cash expenditures of approximately $13 million to $14 million in 2009 as we advance our next clinical trial.

After the organizational change is made over the past several months, including those we just announced, we believe we have the right team and infrastructure in place to permit us to pursue cortical stimulation for depression in a prudent and cost-effective manner. We have retained the necessary clinical, research and engineering personnel and capabilities required to design, implement, and run trials in implantable neurological devices, and to monitor and close out ongoing and past trials.

I'd like to spend a few minutes now discussing our ongoing depression research, why we continue to be attracted to depression, and why we believe that our cortical stimulation technology shows promise for treating this large patient population. There are roughly 5 million depression patients in the US alone who have already failed four or more treatments and are generally referred to as treatment resistant. These are patients who are usually in their working years and are actively seeking medical attention, which leads to an extraordinary cost to the US economy each year.

There's a great deal of attention and focus on devices with the potential to treat severe depression. And this area is widely considered to be one of the biggest future opportunities in medical technology. In particular, there is considerable scientific evidence to support neurostimulation as an effective treatment for this population. Electroconvulsive shock treatment is administered to over 100,000 patients annually, even though its effects can be transient and patients can experience significant side effects such as memory loss.

There are also many research studies supporting the efficacy of brain stimulation for the treatment of depression, including many specific studies supporting stimulation of our target region, the dorsal lateral, prefrontal cortex. We believe that we're focused on the right opportunity and have a technology with significant potential to address this market.

PROSPECT is our initial feasibility study examining the safety and efficacy of our cortical stimulation system for the treatment of this very severe and resistant depression population. On our past earnings calls, we've shared the initial promising results from this trial. Just last month, we reported the long-term results, Northstar and our investigators remain very encouraged. We've seen a demonstrated difference between active and controlled patients across multiple outcome measures and the results appear to continue to improve with time.

As previously reported, at mean follow-up of one year, four of our 11 patients had reached the classical responder threshold of a 50% reduction in symptoms as measured by the Hamilton Depression Rating Scale and a fifth patient was at 49% improvement. We have also seen continued improvement in mean symptom scores on these patients in our long-term follow-up. Importantly, we have additional data on electrode location that we believe may help improve the results further in our next study.

If our cortical stimulation therapy is ultimately approved, we believe this therapy will have significant benefits over existing treatment options, as well as other treatment options in development, such as deep brain stimulation. Cortical stimulation is much less invasive than deep brain stimulation treatments currently being studied. They can be performed safely by a much larger set of clinicians and in standard operating rooms throughout the US. We are now in the process of working with the FDA and our clinical partners to begin a second trial building on the significant learnings from our PROSPECT trials, including refinements to electrode location and stimulation settings.

We've also been developing enhancements to our device system for this trial that will further tailor it for our depression therapy. We recently submitted an IDE supplement to the FDA for our PROSPECT II study and we expect to be enrolling patients by the end of the year. Under this plan, we expect to have data from this new trial by the end of 2009. From a resource standpoint, at the end of 2009, we anticipate having approximately $53 million of cash and investments available to advance this program to a pivotal trial, if appropriate.

I hope that you take away from my comments our continuing enthusiasm for our depression program. We remain highly focused on moving our depression therapy forward in this important market and believe that we have the right operating plan and cost structure to pursue the significant treatment-resistant depression opportunity in a physically responsible manner.

In addition to our operational focus, we continue to be engaged in an active, extensive process, working with our Board and our advisors, including our financial advisor, Leerink Swann, to evaluate other strategic alternatives that may be available to us to enhance shareholder value. Among others, these alternatives could include a strategic partnership, a sale of the company, or a licensing transaction. Northstar and the Board are committed to working through this important process in a diligent and timely manner.

Having said that, as I'm certain you appreciate, these discussions are sensitive in nature, can take time, and are confidential. Therefore, we cannot comment with any specificity about the details of this part of our strategic review process at this time.

With that, I'll turn the call over to Ray to review our financial position and most recent quarterly results and to provide additional financial details about our revised plan and the impact our restructuring is expected to have on our use of cash going forward.

Ray Calvert

Thanks, John. I'll start my remarks today by reviewing the financial results of the second quarter and then provide additional insight into the financial implications of our strategic refocus and our related cost reductions we announced today. We ended the second quarter of 2008 with $74 million in cash and investments compared to $77.9 million at the end of the first quarter. Cash used during the quarter of $3.9 million reflects a 30% reduction compared to the $5.6 million used during the first quarter of 2008.

Operating losses for the second quarter decreased 42% to $4.8 million compared to $8.3 million reported for the second quarter last year. Our second quarter 2008 net loss was $4.1 million, which is a 41% decrease from the net loss of $7 million for the same period in 2007. The composition of the current year operating and net losses reflect reduced current year research and development expenses, primarily due to the completion of our Everest pivotal trial as well as lower overall period-over-period costs, as we recognized the impact of our February 2008 refocusing and related cost reduction efforts.

Interest income declined during the current quarter compared to last year, due primarily to reduced yields and our invested funds combined with lower overall average cash and investment balances. Our investments are performing as expected, simply at lower yields, reflecting the lower overall interest rate environment compared to a year ago.

Before I discuss our expectations for our future use of cash, let me give you some additional details of the restructuring that John discussed earlier. We announced today that we'll be reducing our staffing across the organization by an additional 20 employees, leaving us with 38 going forward. We expect to incur cash costs of just under $1 million related to termination benefits, including non-cash charges related to the acceleration of past equity awards of approximately $200,000, the majority of which will be recognized in the third quarter.

Once fully implemented, we expect to realize annual compensation related savings related to this most recent reduction in force of $2.5 million to $3.0 million. Coupled with our RIF earlier this year, we have reduced our workforce by approximately 60% since we learned the results of our EVEREST trail, resulting in estimated ongoing annual personnel cost reductions of $5 million to $6 million.

Given the timing of severance and other cost reduction steps, we do not expect the impact of today's announced actions to materially change our full year 2008 cash use. We expect net use of cash of approximately $8 million over the last two quarters of this year. However, we do expect ongoing operating expenses and related use of cash for the remaining quarters of this year, excluding the impact of the latest workforce reduction and other restructure related cost to decrease in comparison to Q2, as the savings from our strategic focus and cost reduction efforts are realized. Our ongoing cost structure now stands at approximately the same level as during 2003, 2004, and 2005 when Northstar was a privately-held development stage company.

As John noted earlier, as we look out to 2009, considering our revised strategic plan and the impact of our February and July restructuring, we anticipate ongoing annual net cash use of approximately $13 million to $14 million, resulting in an expected cash and investment balance of approximately $53 million at the end of 2009. We previously stated that we expected our cash and investments would last into 2011. However, we now expect that our cash will last into 2012. This expectation assumes that we significantly increase expenses in the back half of 2010 and throughout 2011 based on the assumption of conducting a larger scale or pivotal trial to evaluate our depression therapy at that time.

We will now open the call for questions. Thank you.

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