1. ORGANIZATION AND BASIS OF PRESENTATION

MELA Sciences, Inc., a Delaware corporation (the “Company”), is a medical device company focused on the commercialization of our flagship product, MelaFind^®, and the further design and development of MelaFind^® and our technology. MelaFind^® is a non-invasive, point-of-care (in the doctor’s office) instrument to aid in the detection of melanoma. MelaFind^® features a hand-held component that emits light of multiple wavelengths to capture digital data from clinically atypical pigmented skin lesions. The data are then analyzed utilizing sophisticated classification algorithms that were ‘trained’ on our proprietary database of melanomas and benign lesions, in order to provide information to assist in the management of the patient’s disease, including information useful in the decision of whether to biopsy the lesion.

The components of the MelaFind^® system include:

In November 2011, the Company received written approval from the U.S. Food and Drug Administration (“FDA”) for the MelaFind^® Pre-Market Approval (“PMA”) application and in September 2011 received Conformite Europeenne (“CE”) Mark approval for MelaFind^® . On March 7, 2012, the Company installed the first commercial MelaFind^® systems, and proceeded with the commercial launch of its breakthrough product for melanoma detection.

The Company is continuing the controlled and deliberate commercial launch of MelaFind^® throughout the United States and Germany. As of June 30, 2013 there were 145 MelaFind^® systems installed. Also during the current quarter, the Company continued its Post-Approval Study (“PAS”) evaluating the sensitivity of physicians in diagnosing melanomas and high-grade lesions and the false positive rate after using MelaFind^®. The Company anticipates that it will continue to incur net losses for the foreseeable future as it proceeds through the commercial launch of the MelaFind^® device and the PAS.

The unaudited condensed financial statements included herein have been prepared from the books and records of the Company pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”) for reporting on Form 10-Q. The information and note disclosures normally included in complete financial statements prepared in accordance with generally accepted accounting principles in the United States (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. The interim financial statements should be read in conjunction with the audited financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2012.

The Company’s management is responsible for the financial statements included in this document. The Company’s interim financial statements are unaudited. Interim results may not be indicative of the results that may be expected for the year. However, the Company believes all adjustments considered necessary for a fair presentation of these interim financial statements have been included and are of a normal and recurring nature.

In June 2012, the Company entered into a sales agreement with Cowen and Company, LLC, to sell shares of the Company’s common stock through an “at-the-market” equity offering program (the “ATM Program”), which was terminated on February 15, 2013. During the quarter ended March 31, 2013, the Company sold approximately 4.7 million shares under the ATM Program for gross and net proceeds of approximately $8.8 million and $8.5 million, respectively. During the term of the ATM Program, the Company sold a total of approximately 6.6 million shares for aggregate gross and net proceeds of approximately $14.4 million and $13.8 million, respectively.

On February 12, 2013 the Company entered into an underwriting agreement, relating to the public offering of 6.1 million shares of the Company’s common stock, at a price to the public of $1.30 per share. The gross proceeds to the Company from the sale of the common stock totaled $7.9 million. After deducting the underwriters’ discounts and commissions and other offering expenses payable by the Company, net proceeds were approximately $7.3 million. The offering closed on February 15, 2013. The common stock was offered and sold pursuant to the Company’s Prospectus dated June 1, 2010 and the Company’s Prospectus Supplement filed with the Securities and Exchange Commission (the “SEC”) on February 12, 2013, in connection with a takedown from the Company’s then current shelf registration statement on Form S-3 (File No. 333-167113) declared effective by the SEC on June 1, 2010.

On March 15, 2013, the Company executed definitive loan documents finalizing a $10 million loan with a venture capital lender (“Lender”). Of the $10 million, $6 million was funded on March 15, 2013 and the Company will have the option to draw down the remaining $4 million through March 17, 2014, subject to the satisfaction of meeting certain sales and revenue targets. The loan matures 42 months from the initial closing and bears interest at a variable rate adjusted for changes in the prime rate but not less than 10.45% per year. For the period from the loan’s inception to June 30, 2013 the interest rate was 10.45%. During the first 12 months the loan is outstanding, only interest will be paid to the Lender and after that the Company will make 30 equal payments of principal and interest until maturity. The loan is secured by a general lien against all of the Company’s assets, other than the Company’s intellectual property assets. In addition, the Lender has a security interest in the proceeds of the sale of any of the Company’s intellectual property assets. The Company must also maintain various non-financial covenants including adhering to limits on incurring additional debt. In addition, the payment of dividends or distributions to stockholders is prohibited.

Upon executing the loan documents on March 15, 2013 the Company became obligated to issue to the Lender a warrant to purchase shares of the Company’s common stock upon approval by the Company’s stockholders of a proposal to increase the Company’s number of authorized shares of common stock at its 2013 Annual Meeting of Stockholders. The number of shares that could be acquired upon exercise of the warrant and the exercise price per share, were not fixed on March 15, 2013 but would be determined when the warrant was issued based on a defined formula using trading prices of the Company’s common stock during certain periods prior to the issuance of the warrant. The Company’s stockholders approved the increase in the number of authorized shares of common stock on April 25, 2013 and on April 26, 2013 the warrant was issued to the Lender. The terms of the warrant were fixed on the date of issuance whereby the Lender received a warrant to purchase 693,202 shares of common stock at an exercise price of approximately $1.12 per share (“Warrant”). The Warrant expires on April 26, 2018.

For financial reporting purposes, the $6 million funded by the Lender on March 15, 2013 was allocated first to the fair value of the Company’s obligation to issue the warrant (“Warrant Obligation”) that totaled approximately $563,000 and the balance was reduced further by the Lender’s costs and fees (“Costs”), resulting in an initial carrying value of the loan of approximately $5.3 million. The Company used a level 3 fair value measurement to determine fair value of the Warrant Obligation, which has significant unobservable inputs as defined in Accounting Standards Codification 820 “Fair Value Measures”. During the period from the loan inception date until the Warrant Obligation was fulfilled and the Warrant was issued, the Warrant Obligation was reflected as a long-term liability at fair value. Changes in the fair value (“mark-to-mark adjustments”) of the Warrant Obligation were included in operating results. The fair value of the Warrant Obligation was determined using the Monte Carlo pricing model that used various assumptions that included; a stock prices ranging from $1.16 to $1.18 per share, volatility of 77%, time to maturity of 5 years, exercise prices ranging from $1.15 to $1.16 and a risk free interest rate of return of .84%. Due to the nature of the Monte Carlo model, a 10% change in the underlying unobservable inputs would not have a significant impact on the fair value.

The value of the Warrant Obligation combined with the Costs resulted in an initial loan discount of approximately $727,000. In addition, the Company is obligated to pay the Lender a fee of $425,000 at the maturity of the Loan (referred to as “Fee” or “Long-term interest payable”). The loan discount and the Fee are being amortized as additional interest expense over the life of the loan using the interest method. The unamortized loan discount at June 30, 2013 was approximately $638,000. As discussed above, prior to the terms of the warrant being fixed on April 26, 2013, the Warrant Obligation fell within the scope of Accounting Standards Codification 815 “Derivatives and Hedging” (“ASC 815”) and therefore the Warrant Obligation was accounted for as a derivative reflected as a long-term liability until the Warrant was issued on April 26, 2013. The terms of the Warrant upon issuance no longer required derivative accounting under ASC 815 and therefore the fair value of the Warrant was classified within stockholders equity.

The aggregate future principal payments due under this $6 million loan are as follows (amounts in thousands):

The Company faces certain risks and uncertainties which are present in many emerging medical device companies regarding future profitability, ability to obtain future capital, protection of patents and intellectual property rights, competition, rapid technological change, government regulations, changing health care marketplace, recruiting and retaining key personnel, and reliance on third party manufacturing organizations.

LIQUIDITY

As of June 30, 2013 the Company had approximately $15 million in cash and cash equivalents and for the six months ended June 30, 2013 cash used in operations totaled approximately $10.5 million. As the result of these factors, management has recently put in place a series of cost reduction programs that included staff reductions, the elimination or deferral of all nonessential projects and activities, including fixed asset additions, and the scaling back or discontinuance of general corporate activities (collectively referred to as “Cost Reduction Plan”.) Management believes, based on current estimates, that cash and cash equivalents held at June 30, 2013 combined with estimated revenue and the effect of the Cost Reduction Plan will result in the Company having the ability to fund operations and meet its debt service obligations for at least the next twelve months. Should the Company experience unforeseen expenses, or if anticipated revenues are not realized, the effect could negatively impact management’s estimated operating results over the next twelve months. The Company has outstanding long-term debt that contains non-financial covenants. Failure to maintain these covenants for any reason would represent an event of default and would allow the Lender to demand the immediate and full payment of over $6 million. If the Company was required to prepay the long-term debt, it would have an immediate and material adverse impact on the Company’s financial position and its ability to fund operations prospectively. The Company’s ability to fund operations beyond twelve months is not assured and will be impacted by market acceptance of MelaFind^® and the related growth in revenues, potential capital raises as discussed in more detail below, and cost cutting measures that are in place currently or may be put into place in the future. In addition, the Company anticipates that long-term it will need to raise substantial funds to broaden the commercialization of MelaFind^®, including further development of a direct sales force and expansion of the Company’s operations. The timing and amount of any additional funding the Company may require will be affected by the commercial success of its MelaFind^® product. For example, the funding could be in the form of either additional equity or debt financing, to the extent permitted under the loan agreement with the Lender, or in exchange for product rights in all or certain geographies. There can be no assurances that the Company will be able to raise additional financing in the future. Additional funds may not become available on acceptable terms, and there can be no assurance that any additional funding that the Company does obtain will be sufficient to meet the Company’s needs in the long term. Any additional funding that the Company may obtain in the future could be dilutive to common stockholders and could provide new investors with rights and preferences senior to common stockholders. In the event that the Company is unable to raise additional funds, the Company would reduce or eliminate expansion plans and may need to discontinue operations.

2. INVENTORIES

Inventories consist of finished products that are stated at the lower of cost (first-in, first-out) or market value. The inventories are purchased items which are consumables to be sold for use in the operation of the MelaFind^® systems. As of June 30, 2013 the reserve for obsolete inventory totaled $325,000.

3. USE OF ESTIMATES

The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires the use of estimates and assumptions by management that affect reported amounts of assets and liabilities and disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. The most significant estimates relate to stock-based compensation arrangements, the use of estimates to determine the elements of our revenue and deferred revenue, accrued expenses, and the warrant liability. Actual results could differ from these estimates. Estimates of future operating results are based upon numerous factors including past experience, known information and subjective estimates and assumptions. Actual future operating results could be materially different from management’s estimates and unforeseen events could adversely affect management’s estimates.

4. RECENT ACCOUNTING PRONOUNCEMENTS

The Financial Accounting Standards Board has issued a number of new accounting standards that require future adoption. Based on the Company’s initial review of these new standards, none are expected to have a material impact on the Company’s financial statements.

5. FIXED ASSETS

During the six months ended June 30, 2013, the Company capitalized approximately $3.8 million of MelaFind^® system costs and as of June 30, 2013 the total capitalized cost of MelaFind^® systems was approximately $10.1 million. The Company reviews its long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of a long-lived asset is not recoverable. While there have been no events or circumstances that would indicate any of the Company’s long-lived assets, including the Company’s inventory of MelaFind^® systems, are not recoverable; however, if in the future there is a lack of market acceptance of MelaFind or if estimated revenues from MelaFind^® do not meet Management’s expectations, than there could be an impairment loss for these assets that could be material to the Company’s financial position and results of operations.

6. NET LOSS PER COMMON SHARE

Basic net loss per common share excludes dilution for potentially dilutive securities and is computed by dividing loss attributable to common stockholders by the weighted average number of common shares outstanding during the period. Diluted net loss per common share gives effect to dilutive options, warrants and other potential common shares outstanding during the period. Diluted net loss per common share is equal to the basic net loss per common share since all potentially dilutive securities are anti-dilutive for each of the periods presented. Potential common stock equivalents excluded consist of stock options and warrants which are summarized as follows:

7. COMPREHENSIVE LOSS

For all periods presented, the Company had no comprehensive income items and accordingly there is no difference between the reported net loss and per share amounts per the Statement of Operations and comprehensive net loss and related per share amounts.

8. STOCK-BASED COMPENSATION

On April 25, 2013, at the Company’s 2013 Annual Meeting of Stockholders, the Company’s stockholders approved the Company’s adoption of the new 2013 Stock Incentive Plan having terms substantially similar to the Company’s 2005 Stock Incentive Plan (the “2005 Plan”) and having 3.5 million shares available for issuance in respect of awards made there under. As of June 30, 2013, the aggregate number of shares of common stock remaining available for issuance in respective of awards which may be made under both the 2013 Stock Incentive Plan and the 2005 Plan was approximately 4 million.

On February 11, 2013, the Company’s former Chairman, President and Chief Executive Officer (“Former CEO”) contractually agreed (“Forbearance Agreement”) to not exercise 900,000 fully vested options until such time as the stockholders of the Company approve an increase in the number of authorized shares of the Company’s common stock or, if earlier, the Company’s written consent. On April 25, 2013, the Company’s stockholders approved an increase in the authorized shares of common stock and therefore the restriction placed on the Former CEO’s ability to exercise the 900,000 fully vested options lapsed. For financial reporting purposes, the Forbearance Agreement was accounted for at the time it was executed as a cancellation with no concurrent grant and therefore upon the lapsing of the exercise restriction on April 25, 2013, the Company recognized additional stock compensation of approximately $423,000.

On April 25, 2103, the Company granted stock options to numerous employees to acquire a total of approximately 1.3 million shares of common stock at an exercise price of $1.24. Included therein, was a grant to the Company’s Former CEO to acquire 1 million shares of common stock of which a quarter vested immediately and the balance vest based upon the achievement of defined cash flow, revenue or stock price targets. The fair value of the Former CEO’s vested options resulted in stock based compensation recognized for the three months ended June 30, 2013 of approximately $200,000.

During May 2013 the Company issued 75,000 shares of common stock to two consultants as compensation for service rendered. In connection therewith, the Company recognized stock compensation of approximately $80,000 for the three months ended June 30, 2013.

On June 15, 2013 the Former CEO resigned from the Company. As of the date of termination the Former CEO held approximately 1.2 million vested and 750,000 unvested options with exercise prices of $1.24 or $3.75. In accordance the stock option plan, the unvested options expired on date of resignation and are available for future grants under the stock option plan. The Former CEO has 90 days from termination to exercise vested options. After 90 days, any unexercised options will expire and become available for future grants under the stock option plans.

On June 21, 2013, the Company granted stock options to the Interim Chief Executive Officer to acquire 200,000 shares of common stock at an exercise price $0.73 per share. The options vest quarterly over one year and vesting may be accelerated under certain defined circumstances. The total fair value of the grant that will be recognized as compensation expense over the vesting period is approximately $96,000. The amount of stock compensation expense recognized in the three months ended June 30, 2013 was not material.

9. WARRANTS

In connection with a committed equity facility with Kingsbridge Capital Limited (“Kingsbridge”) in May 2009, the Company issued a 5-year warrant to Kingsbridge to purchase up to 200,000 shares of the Company’s common stock at an exercise price of $11.35 per share. These 200,000 warrants are outstanding at June 30, 2013 and expire on May 7, 2014.

As discussed in detail in Note 1, on March 15, 2013 the Company executed definitive loan documents finalizing a $10 million loan with a venture capital lender. In connection with the loan, the Lender received a warrant to purchase 693,202 shares of the Company’s common stock at an exercise price of approximately $1.12 per share. This warrant was issued April 26, 2013 and expires five years from the date of issuance.

No warrants were exercised during the six months ended June 30, 2013 and 2012, respectively.

10. STOCKHOLDERS’ EQUITY

On April 25, 2013 the Company’s stockholders voted to approve an increase in the number of authorized shares if common stock from 45,000,000 to 95,000,000.

11. FAIR VALUE OF FINANCIAL INSTRUMENTS

Authoritative guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The fair value hierarchy consists of three broad levels as described below:

As discussed in detail in Note 1, the Company’s Warrant Obligation was valued based on Level 3 inputs. The Company had no other assets or liabilities carried at fair value during the three and six month periods ended June 30, 2013 and 2012.

12. SUBSEQUENT EVENT

As discussed in Note 1, in response to recurring operating losses and limited liquidity, during August 2013 the Company’s Board of Directors approved the Cost Reduction Plan that included a reduction in work force and the prospective elimination or deferral of all nonessential projects and activities and the scaling back or discontinuance of general corporate activities. The communication to effected employees was made during August 2013. In connection therewith, the Company will record a charge for employee termination benefits totaling approximately $83,000 that will be reflected in the statement of operations as increases in cost of revenue, research and development and selling, general and administrative expenses of approximately $14,000, $16,000 and $53,000 respectively in the third quarter of 2013. Employee termination benefits will be paid during August 2013.

The aggregate future principal payments due under this $6 million loan are as follows (amounts in thousands):

Potential common stock equivalents excluded consist of stock options and warrants which are summarized as follows: