Number of Shares		Exercise Price		Expiration Date
50,000		$    0.50		May 2011
2,500,000		$    0.50		November 2010
2,186,668		$    0.75		May 2012
7,000,000		$    0.75		June 2011
50,000		$    1.00		May 2011
35,000		$    1.00		July 2008
50,000		$    1.50		May 2011
50,000		$    2.00		May 2011
50,000		$    2.50		May 2011
410,400		$    2.50		April 2009
1,641,600		$    4.00		April 2009
1,759		$  19.90		October 2008
14,025,427		$    1.15

G.         Stock-Based Compensation

Below is a summary of Aeolus stock option activity during the nine-month period ended June 30, 2008:

		Shares			Weighted Average Exercise Price			Weighted Average Remaining Contractual Term		Aggregate Intrinsic Value
Outstanding at September 30, 2007			3,873,617		$	2.72		7.3 years	$	2
Granted			120,000		$	0.42
Exercised			---		$	---
Forfeited			(113,336	)	$	0.87
Outstanding at June 30, 2008 (unaudited)			3,880,281		$	2.70		6.6 years	$	1
Exercisable at June 30, 2008 (unaudited)			3,776,948		$	2.76		6.6 years	$	---

For the nine months ended June 30, 2008 and 2007, 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.

 

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The details of stock options outstanding at June 30, 2008 were as follows:

		Options Outstanding							Options Exercisable
Range of Exercise Prices		Number Outstanding at June 30, 2008		Weighted Average Exercise Price			Weighted Average Remaining Contractual Life		Number Exercisable at June 30, 2008		Weighted Average Exercise Price
$0.40 - 0.60		546,050		$	0.54		8.9 years		471,050		$	0.55
$0.68 - $0.80		464,161		$	0.75		8.0 years		464,161		$	0.75
$0.81 - $0.89		388,035		$	0.85		7.4 years		388,035		$	0.85
$0.90		392,050		$	0.90		8.4 years		371,217		$	0.90
$0.91 - $1.45		224,500		$	1.04		7.8 years		217,000		$	1.04
$1.50		1,256,015		$	1.50		5.1 years		1,256,015		$	1.50
$1.52 - $5.10		394,391		$	2.86		5.9 years		394,391		$	2.86
$6.25 - $31.88		166,280		$	20.48		2.9 years		166,280		$	20.48
$50.9375		2,999		$	50.94		1.8 years		2,999		$	50.94
$51.25		45,800		$	51.25		1.8 years		45,800		$	51.25
$0.40 - $51.25		3,880,281		$	2.70		6.6 years		3,776,948		$	2.76

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

		For the nine months June 30,
		2008				2007
Research and development expenses		$	43			$	161
General and administrative expenses			229				283
Total stock-based compensation expense		$	272			$	444

 

The total deferred compensation expense for outstanding and unvested stock options was $8,000 as of June 30, 2008.  The weighted average remaining recognition period for the total deferred compensation expense is two months. The fair value of the options associated with the above compensation expense for the nine months ended June 30, 2008 and 2007, 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 June 30,
		2008		2007
Dividend yield		0%		0%
Expected volatility		197%		191% – 195%
Risk-free interest rate		3.8% - 4.6%		4.5% - 5.1%
Expected option life after shares are vested		10 years		10 years

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.

 

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I.           Subsequent Events

On August 1, 2008, the Company entered into a Securities Purchase Agreement (the “Purchase Agreement”) with three accredited institutional investors  (the “Investors”) pursuant to which the Company agreed to sell to the Investors  (and one or more additional accredited investors)  units comprised of senior unsecured convertible notes of the Company (the “Notes”), in an aggregate principal amount of up to $5,000,000, which shall bear interest at a rate of 7% per year and mature on the 30-month anniversary of their date of issuance, and warrants to purchase up to an aggregate of 10,000,000 additional shares of Common Stock (the “Warrant Shares”), each with an initial exercise price of $0.50 per share, subject to adjustment pursuant to the warrants (the “Warrants”). Each unit (collectively, the "Units") is comprised of $1,000 in Note principal and Warrants to purchase up to 2,000 shares of the Company's common stock, par value $0.01 per share (the “Common Stock”), and has a purchase price of $1,000.

The Notes will be convertible, at the Investors' sole election, into shares of Common Stock at any time and from time to time.  The conversion price of the Notes (including the $0.20 floor and $0.75 ceiling price with respect to Notes issued at Election Closings) and the exercise price of the Warrants are subject to adjustment in the event of a stock dividend or split, reorganization, recapitalization or similar event.  Additionally, the conversion price of the Notes and the exercise price of the Warrants may be reduced in the event the Company issues securities at a price per share lower than the then current conversion price of the Notes.

On August 1, 2008, the Company sold and issued to the Investors 500 Units comprised of Notes in the aggregate principal amount of $500,000 and Warrants to purchase up to 1,000,000 shares of Common Stock for an aggregate purchase price of $500,000 (the "Financing").  The Notes and Warrants were issued pursuant to the Purchase Agreement. The Investors have also agreed, upon the satisfaction of certain conditions by the Company pursuant to the Purchase Agreement, to purchase an additional 125 Units on each of September 2, 2008, October 1, 2008, November 3, 2008 and December 1, 2008 (the "Subsequent Closings"), in each case for an aggregate purchase price of $125,000.  The Notes issued in the Financing and at the Subsequent Closings have, or will have, an initial conversion price of $0.35 per share, subject to adjustment pursuant to the Notes.  In addition, the Investors (and one or more additional accredited investors) have the option to purchase up to an additional 4,000 Units, in one or more closings (each, an "Election Closing"), and at their sole option at any time on or before February 1, 2010. The additional Units sold at an Election Closing would also be sold by the Company at a purchase price of $1,000 per Unit, except that the initial conversion price of the Notes issued in an Election Closing will equal the volume weighted average closing sale price for the Common Stock for the sixty consecutive trading day period ending on the trading day immediately preceding such Election Closing, provided that such initial conversion price may not be less than $0.20 per share or greater than $0.75 per share, in each case subject to adjustment pursuant to the Note.

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.

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 trails 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, 2007. 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.

 

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Operations Summary

We are developing a series of catalytic antioxidant molecules to protect against the damaging effects of reactive oxygen derived molecules, commonly referred to as free radicals. Free radicals cause damage in a broad group of diseases and conditions. Our initial target applications will be the use of our catalytic antioxidants for the treatment of mustard gas exposure, protective agent against radiation exposure, cancer radiation therapy and amyotrophic lateral sclerosis, also known as “ALS” or “Lou Gehrig’s disease.”    However, further development of AEOL 10150 in radiation therapy and ALS, if any, will be dependent upon future specific financing for this development or a partnership and the results of our ongoing studies of AEOL 10150 for the treatment of mustard gas exposure.  We have reported positive safety results from two Phase I clinical trials of AEOL 10150 in patients diagnosed with ALS with no serious adverse events noted.   The Company is also conducting an additional pre-clinical study of AEOL 11207 for the treatment of patients with Parkinson’s Disease

We do not have any revenue 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

We believe we have adequate financial resources to fund our operations through the second quarter of fiscal year 2009, but in order to fund on-going operating cash requirements beyond the second quarter of fiscal year 2009, or to accelerate or expand our programs, we will need to raise significant additional funds. Our need for additional financing is discussed under “Liquidity and Capital Resources.”

Results of Operations

Three months ended June 30, 2008 versus three months ended June 30, 2007

We had a net loss of $580,000 for the three months ended June 30, 2008 versus a net loss of $509,000 for the three months ended June 30, 2007.

Research and development (“R&D”) expenses increased $18,000, or 9%, to $210,000 for the three months ended June 30, 2008 from $192,000 for the three months ended June 30, 2007.  The higher level of R&D expenses during the current quarter is a result of an increase in preclinical and manufacturing costs as well as patent fees offset by a decline in consulting and clinical expenses.   The Company’s R&D activities were focused on preclinical activities during the three months ended June 30, 2008 whereas during the three months ended June 30, 2007 our research activities were focused on our clinical program.  The Company has four pre-clinical programs underway for the study of the effects of our drug candidates on exposure of mustard gas on the skin, the effects of our drug candidates on the exposure of mustard gas in the lungs, for the treatment of colitis and for the treatment of Parkinson’s disease.

R&D expenses for our antioxidant program have totaled $34,266,000 from inception through June 30, 2008.  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.

General and administrative (“G&A”) expenses increased $40,000, or 13%, to $360,000 for the three months ended June 30, 2008 from $320,000 for the three months ended June 30, 2007.  G&A expenses were higher during the three months ended June 30, 2008 versus June 30, 2007 due to the engagement of a consulting firm to assist the Company in strategic activities resulting in $35,000 in consulting fees.  In addition, legal fees increased due to increased United States Securities and Exchange Commission compliance activities.

Nine months ended June 30, 2008 versus nine months ended June 30, 2007

We had a net loss of $1,918,000 for the nine months ended June 30, 2008, versus a net loss of $2,002,000 for the nine months ended June 30, 2007.

R&D expenses decreased $137,000, or 16%, to $732,000 for the nine months ended June 30, 2008 from $869,000 for the nine months ended June 30, 2007.   The lower level of R&D expenses during the current period reflects a lower amount of employment, consulting and manufacturing expenses offset by a higher level of pre-clinical and patent expenses.  Employment and consulting expenses were $103,000 during the nine months ended June 30, 2008 versus $371,000 during the nine months ended June 30, 2007.  The decline in employment and consulting expenses reflects that we were completing our multiple dose clinical trail and were in the process of manufacturing bulk quantities of our lead drug candidate, AEOL 10150 during the nine months ended June 30, 2007, whereas during the current period we had restructured our research program to utilize outside research institutions and grants to perform our research activities and therefore had a lower level of employment and consulting expenses.   During the nine months ended June 30, 2008, manufacturing costs were $117,000 compared to $226,000 during the nine months ended June 30, 2007.  Offsetting these declines was an increase of $255,000 in outside research services as a result of

 

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our transition to outsourcing of research activities during the current period and $173,000 in patent fees as a result of an increase in patent filing activity.

G&A expenses decreased $258,000, or 18%, to $1,138,000 for the nine months ended June 30, 2008 from $1,396,000 for the nine months ended June 30, 2007.  G&A expenses were lower during the nine months ended June 30, 2008 versus the nine months ended June 30, 2007 due to a decline in employment costs, stock compensation expense, investor relations expense and insurance expense.  Employment costs declined by $159,000 during the nine months ended June 30, 2008 compared to the nine months ended June 30, 2007, as the current period reflects employment costs of our sole employee, our Chief Executive Officer, whereas the prior year period includes employment costs of two additional executive officers as well as severance and bonus costs to three executive officers.  Stock compensation expense decreased by $54,000 as a result of the lower headcount during the current period.  Investor relations expenses declined by $49,000, as a result of a decrease in the level of activity for our investor relations program.  In addition, insurance expense declined by $27,000 as a result of lower premiums.

During the nine months ended June 30, 2008, we recorded an “other-than-temporary” impairment charge of $49,000 based upon reduced market values of our auction-rate securities as determined based upon investment statements as of June 30, 2008 received from UBS Financial Services, Inc.   During the nine months ended June 30, 2008, the auction rate securities which the Company has invested in have experienced auction failures as a result of the current disruptions in the credit markets.  This is the first time the Company has experienced this type of event for its holdings of auction-rate securities and the Company believes that prior to February 13, 2008, the Company’s investment advisor, UBS, had not had a failed auction.  The Company understands that the failure of auctions is broad based and not limited to those securities held by the Company.  As a result of the failed auctions, our auction-rate securities are currently not liquid. Furthermore, the Company cannot predict how long they will remain illiquid.

During the three months ended June 30, 2007, we recognized $225,000 in income as a result of the forgiveness of a portion of the principal balance of a note payable from Elan.

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, 2008, we had $181,000 of cash, a decrease of $1,546,000 from September 30, 2007. The decrease in cash was primarily due to the $1,870,000 loss from operations for the nine months ended June 30, 2008.  On August 1, 2008, the Company completed a $500,000 convertible note financing with an additional $500,000 expected to be invested over the next four months (See Note I).  The investors also have an option to invest an additional $4.0 million over the next eighteen months.  We believe we have adequate financial resources to conduct operations through the second quarter of fiscal year 2009, 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.

We incurred significant losses from operations of $1,870,000 and $3,300,000, and cash outflows from operations of $1,383,000 and $3,079,000, for the nine months ended June 30, 2008 and for the fiscal year ended September 30, 2007, 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 explore other strategic and financial alternatives, including a merger with another company, the sale of stock, 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 a 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.

 

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Off-Balance Sheet Arrangements

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, cash equivalents and investments available for sale, 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 three months ended June 30, 2008. 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.

As of the end of the period covered by this report, we carried out an evaluation, under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Accounting Officer, of the effectiveness of our disclosure controls and procedures (as defined in Rule 13a-15(e)) pursuant to Rule 13a-15 of the Securities and Exchange Act of 1934 as amended. Based upon their evaluation, our Chief Executive Officer and Chief Accounting Officer have concluded that our disclosure controls and procedures are effective.

No change in our internal control over financial reporting occurred during our last fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

Management is aware that there is a lack of segregation of duties due to the small number of employees and consultants addressing the Company’s general administrative and financial matters. However, management has determined that, considering the employees involved and the control procedures in place, risks associated with such lack of segregation are not significant and any potential benefits of adding employees or consultants to clearly segregate duties do not justify the expenses associated with such increases at this time.

PART II. - OTHER INFORMATION

ITEM 1.                      Legal Proceedings.

Information regarding reportable legal proceedings is set forth in Part I, Item 1, Note E, Notes Payable.

ITEM 1A.                      Risk Factors.

The Company included in its Annual Report on Form 10-K for the fiscal year ended September 30, 2007 a description of certain risks and uncertainties that could affect the Company’s business, future performance or financial condition (“Risk Factors”). There have been no material changes to the risk factors previously disclosed.

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

None.

ITEM 3.                      Defaults Upon Senior Securities.

None.

 

ITEM 4.                      Submission of Matters to a Vote of Security Holders.

None.

ITEM 5.                      Other Information.

 

None.

 

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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.

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 4, 2008	By:	/s/ John L. McManus
		John L. McManus President and Chief Executive Officer (Principal Executive Officer)
Date:                         August 4, 2008	By:	/s/ Michael P. McManus
		Michael P. McManus Chief Financial Officer, Treasurer and Secretary (Principal Financial and Accounting Officer)