Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

 

FORM 10-Q

 

 

(Mark One)

x	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2013

 

¨	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE TRANSITION PERIOD FROM                      TO                     

Commission file number: 001-36003

 

 

CONATUS PHARMACEUTICALS INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware		20-3183915
(State or Other Jurisdiction of Incorporation or Organization)		(I.R.S. Employer Identification No.)
4365 Executive Dr., Suite 200 San Diego, CA		92121
(Address of Principal Executive Offices)		(Zip Code)

(858) 558-8130

(Registrant’s Telephone Number, Including Area Code)

 

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  ¨

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  ¨

Indicate by check mark whether registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer”, “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer		¨		Accelerated filer		¨
Non-accelerated filer		x  (Do not check if a smaller reporting company)		Smaller reporting company		¨

Indicate by check mark whether registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    ¨  Yes    x  No

As of October 31, 2013, the registrant had 15,619,879 shares of Common Stock ($0.0001 par value) outstanding.

 

 

 

---

Table of Contents

CONATUS PHARMACEUTICALS INC.

TABLE OF CONTENTS

 

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements			3
Condensed Consolidated Balance Sheets			3
Condensed Consolidated Statements of Operations and Comprehensive Loss			4
Condensed Consolidated Statements of Cash Flows			5
Notes to Unaudited Financial Statements			6
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations			14
Item 3. Quantitative and Qualitative Disclosures about Market Risk			21
Item 4. Controls and Procedures			21
PART II. OTHER INFORMATION
Item 1. Legal Proceedings			22
Item 1A. Risk Factors			22
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds			25
Item 3. Defaults Upon Senior Securities			26
Item 4. Mine Safety Disclosures			26
Item 5. Other Information			26
Item 6. Exhibits			26
SIGNATURES			26
EXHIBIT 31.1
EXHIBIT 31.2
EXHIBIT 32.1
EXHIBIT 32.2

 

2

---

Table of Contents

PART I. FINANCIAL INFORMATION

 

ITEM 1.

FINANCIAL STATEMENTS

Conatus Pharmaceuticals Inc.

(a development stage company)

Condensed Consolidated Balance Sheets

(Unaudited)

 

		September 30, 2013				December 31, 2012
Assets
Current assets:
Cash and cash equivalents		$	35,135,391			$	4,036,091
Marketable securities			24,456,557				3,989,473
Prepaid and other current assets			613,612				76,184
Total current assets			60,205,560				8,101,748
Property and equipment, net			21,805				29,604
Other assets			14,395				14,395
Total assets		$	60,241,760			$	8,145,747
Liabilities, convertible preferred stock and stockholders’ equity (deficit)
Current liabilities:
Accounts payable and accrued expenses		$	774,540			$	1,087,346
Accrued compensation			381,070				325,555
Total current liabilities			1,155,610				1,412,901
Convertible preferred stock warrant liability			—				160,345
Note payable			1,000,000				1,000,000
Series A Convertible Preferred Stock, $0.0001 par value; 44,827,538 shares authorized, 0 and 42,494,218 shares issued and outstanding at September 30, 2013 and December 31, 2012, respectively			—				32,208,532
Series B Convertible Preferred Stock, $0.0001 par value; 50,300,000 shares authorized, 0 and 36,417,224 shares issued and outstanding at September 30, 2013 and December 31, 2012, respectively			—				31,699,840
Stockholders’ equity (deficit):
Common stock, $0.0001 par value, 120,000,000 shares authorized at September 30, 2013 and December 31, 2012, 15,619,879 shares issued and 15,335,069 shares outstanding, excluding 284,810 shares subject to repurchase at September 30, 2013, 1,207,091 shares issued and 1,052,606 shares outstanding, excluding 154,485 shares subject to repurchase, at December 31, 2012			1,562				105
Additional paid-in capital			127,377,725				470,982
Accumulated other comprehensive income			11,732				551
Deficit accumulated during the development stage			(69,304,869	)			(58,807,509	)
Total stockholders’ equity (deficit)			58,086,150				(58,335,871	)
Total liabilities, convertible preferred stock and stockholders’ equity (deficit)		$	60,241,760			$	8,145,747

See accompanying notes.

 

3

---

Table of Contents

Conatus Pharmaceuticals Inc.

(a development stage company)

Condensed Consolidated Statements of Operations and Comprehensive Loss

(Unaudited)

 

		Three Months Ended September 30,								Nine Months Ended September 30,								Period from July 13, 2005 (Inception) to
		2013				2012				2013				2012				September 30, 2013
Operating expenses:
Research and development		$	1,885,567			$	1,774,322			$	3,970,441			$	4,022,462			$	44,795,589
General and administrative			1,107,668				737,460				2,526,894				2,169,685				20,643,486
Total operating expenses			2,993,235				2,511,782				6,497,335				6,192,147				65,439,075
Other income (expense):
Interest income			7,788				5,705				7,920				22,327				1,366,670
Interest expense			(203,917	)			(17,500	)			(417,661	)			(52,500	)			(1,192,490	)
Other income (expense)			7,911				(4,354	)			(7,040	)			(39	)			234,359
Other financing expense			(139,328	)			(56,700	)			(3,576,750	)			(91,793	)			(4,267,839	)
Total other expense			(327,546	)			(72,849	)			(3,993,531	)			(122,005	)			(3,859,300	)
Net loss			(3,320,781	)			(2,584,631	)			(10,490,866	)			(6,314,152	)			(69,298,375	)
Other comprehensive income (loss):
Net unrealized gains (losses) on marketable securities			11,732				(1,571	)			11,181				6,812				11,732
Comprehensive loss		$	(3,309,049	)		$	(2,586,202	)		$	(10,479,685	)		$	(6,307,340	)		$	(69,286,643	)
Reconciliation of net loss to net income (loss) applicable to common stockholders:
Net loss		$	(3,320,781	)		$	(2,584,631	)		$	(10,490,866	)		$	(6,314,152	)		$	(69,298,375	)
Gain on extinguishment of convertible preferred stock			—				—				11,491,043				—				11,491,043
Deemed distribution from promissory note issuance			—				—				(474,561	)			—				(474,561	)
Net income applicable to participating securities			—				—				(525,616	)			—				—
Net income (loss) applicable to common stockholders-basic		$	(3,320,781	)		$	(2,584,631	)		$	—			$	(6,314,152	)		$	(58,281,893	)
Net income (loss) per share applicable to common stockholders: (Note 2)
Basic		$	(0.28	)		$	(2.55	)		$	—			$	(6.24	)		$	—
Diluted		$	(0.28	)		$	(2.55	)		$	—			$	(6.24	)		$	—
Weighted average shares outstanding used in computing net income (loss) per share applicable to common stockholders:
Basic			11,664,328				1,012,117				4,660,027				1,012,117				—
Diluted			11,664,328				1,012,117				4,660,027				1,012,117				—

See accompanying notes.

 

4

---

Table of Contents

Conatus Pharmaceuticals Inc.

(a development stage company)

Condensed Consolidated Statements of Cash Flows

(Unaudited)

 

		Nine Months Ended September 30,								Period From July 13, 2005 (Inception) to
		2013				2012				September 30, 2013
Operating activities
Net loss		$	(10,490,866	)		$	(6,314,152	)		$	(69,298,375	)
Adjustments to reconcile net loss to net cash used by operating activities:
Depreciation			7,799				6,242				207,065
Share-based compensation expense			101,379				105,751				498,761
Noncash other financing expense			3,618,093				91,793				4,802,291
Acquisition of in-process research and development			—				—				1,250,000
Share-based compensation in lieu of salaries			—				—				659,224
Noncash license expense			—				—				2,249,999
Amortization (accretion) of premium (discount) on investments			42,936				146,676				(78,680	)
Changes in operating assets and liabilities:
Prepaid expenses and other current assets			(537,428	)			2,239				(613,612	)
Other asset			—				—				(14,395	)
Accounts payable and accrued expenses			(312,806	)			(242,306	)			818,376
Accrued compensation			17,634				(273,585	)			330,709
Net cash used in operating activities			(7,553,259	)			(6,477,342	)			(59,188,637	)
Investing activities
Maturities of investments			3,725,000				14,528,000				104,507,865
Purchase of investments			(24,223,839	)			(7,567,942	)			(128,874,010	)
Cash paid to acquire in-process research and development			—				—				(250,000	)
Capital expenditures			—				(15,016	)			(228,870	)
Net cash provided by (used in) investing activities			(20,498,839	)			6,945,042				(24,845,015	)
Financing activities
Issuance of promissory notes			1,001,439				—				7,201,439
Issuance of warrants			113				—				347
Distribution to wholly owned subsidiary in connection with spin-off of Idun			(500,000	)			—				(500,000	)
Issuance of preferred stock for cash, net of offering costs			—				—				53,731,226
Public offering costs			(2,771,546	)			—				(2,771,546	)
Issuance of common stock			61,421,392				14,585				61,507,577
Net cash provided by financing activities			59,151,398				14,585				119,169,043
Net increase in cash and cash equivalents			31,099,300				482,285				35,135,391
Cash and cash equivalents at beginning of period			4,036,091				3,072,839				—
Cash and cash equivalents at end of period		$	35,135,391			$	3,555,124			$	35,135,391
Supplemental disclosure of cash flow information:
Cash paid for interest		$	71,083			$	52,500			$	240,639
Supplemental schedule of non-cash investing and financing activities:
Conversion of notes payable for preferred stock		$	—			$	—			$	6,736,946
Issuance of warrants in conjunction with debt		$	625,792			$	—			$	2,361,223
Issuance of note payable related to acquisition of in-process research and development		$	—			$	—			$	1,000,000

See accompanying notes.

 

5

---

Table of Contents

Conatus Pharmaceuticals Inc.

(a development stage company)

Notes to Condensed Consolidated Financial Statements

(Unaudited)

1. Organization and Basis of Presentation

Conatus Pharmaceuticals Inc. (the Company) was incorporated in the state of Delaware on July 13, 2005. The Company is a biotechnology company focused on the development and commercialization of novel medicines to treat liver disease.

As of September 30, 2013, the Company has devoted substantially all of its efforts to product development, and has not realized revenues from its planned principal operations. Accordingly, the Company is considered to be in the development stage.

The Company has a limited operating history and the sales and income potential of the Company’s business and market are unproven. The Company has experienced net losses since its inception, and, as of September 30, 2013, had an accumulated deficit of $69,304,869. The Company expects to continue to incur net losses for at least the next several years. Successful transition to attaining profitable operations is dependent upon achieving a level of revenues adequate to support the Company’s cost structure.

The accompanying condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) and the rules and regulations of the Securities and Exchange commission (SEC) related to a quarterly report on Form 10-Q. Certain information and note disclosures normally included in annual financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to those rules and regulations. The unaudited interim condensed consolidated financial statements reflect all adjustments which, in the opinion of management, are necessary for a fair statement of the results for the periods presented. All such adjustments are of a normal and recurring nature. The operating results presented in these unaudited condensed consolidated financial statements are not necessarily indicative of the results that may be expected for any future periods. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and the notes thereto for the year ended December 31, 2012 included in the Company’s final prospectus filed with the SEC on July 25, 2013 relating to the Company’s Registration Statement on Form S-1 (File No. 333-189305) for its initial public offering (IPO).

In July 2013, the Company implemented a 1-for-8.25 reverse stock split of its outstanding common stock. The accompanying condensed consolidated financial statements give effect to the reverse split for all periods presented.

In July 2013, the Company completed the IPO of 6,000,000 shares of common stock at an offering price of $11.00 per share. The Company received net proceeds of approximately $59.0 million, after deducting underwriting discounts, commissions and offering-related transaction costs.

2. Summary of Significant Accounting Policies

Principles of Consolidation

The condensed consolidated financial statements at December 31, 2012 include all the accounts of the Company and its wholly-owned subsidiary, Idun Pharmaceuticals, Inc. (Idun). All intercompany balances and transactions have been eliminated in consolidation. In January 2013, the assets and rights related to the drug candidate emricasan were distributed from Idun to the Company. Following that distribution, Idun was spun off from the Company.

Use of Estimates

The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. Actual results could differ from those estimates.

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash, cash equivalents and investments. The Company maintains deposits in federally insured financial institutions in excess of federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to significant risk on its cash. Additionally, the Company established guidelines regarding approved investments and maturities of investments, which are designed to maintain safety and liquidity.

 

6

---

Table of Contents

Cash and Cash Equivalents

The Company considers all highly liquid investments with an original maturity from the date of purchase of three months or less to be cash equivalents. Cash and cash equivalents include cash in readily available checking and money market accounts.

Investments

The Company classifies its investments as available-for-sale and records such assets at estimated fair value in the balance sheet, with unrealized gains and losses, if any, reported as a component of other comprehensive income (loss) within the statements of operations and comprehensive loss and as a separate component of stockholders’ equity (deficit). The Company invests its excess cash balances primarily in corporate debt securities and money market funds with strong credit ratings. Realized gains and losses are calculated on the specific identification method and recorded as interest income. There have been no realized gains and losses for the periods ending September 30, 2013, the year ended December 31, 2012, and for the period from July 13, 2005 (inception) to September 30, 2013.

At each balance sheet date, the Company assesses available-for-sale securities in an unrealized loss position to determine whether the unrealized loss is other-than-temporary. The Company considers factors including: the significance of the decline in value compared to the cost basis, underlying factors contributing to a decline in the prices of securities in a single asset class, the length of time the market value of the security has been less than its cost basis, the security’s relative performance versus its peers, sector or asset class, expected market volatility and the market and economy in general. When the Company determines that a decline in the fair value below its cost basis is other-than-temporary, the Company recognizes an impairment loss in the year in which the other-than-temporary decline occurred. There have been no other-than-temporary declines in value of marketable securities for the periods ended September 30, 2013, the year ended December 31, 2012, and for the period from July 13, 2005 (inception) to September 30, 2013, as it is more likely than not the Company will hold the securities until maturity or a recovery of the cost basis.

Fair Value of Financial Instruments

The carrying amounts of accounts payable, accrued expenses, and accrued compensation are reasonable estimates of their fair value because of the short maturity of these items.

Property and Equipment

Property and equipment, which consists of furniture and fixtures, computers and office equipment and leasehold improvements, are stated at cost and depreciated over the estimated useful lives of the assets (three to five years) using the straight-line method. Leasehold improvements are amortized over the shorter of their estimated useful lives or the lease term.

Long-Lived Assets

The Company regularly reviews the carrying value and estimated lives of all of its long-lived assets, including property and equipment to determine whether indicators of impairment may exist which warrant adjustments to carrying values or estimated useful lives. The determinants used for this evaluation include management’s estimate of the asset’s ability to generate positive income from operations and positive cash flow in future periods as well as the strategic significance of the assets to the Company’s business objective. Should an impairment exist, the impairment loss would be measured based on the excess of the carrying amount of the asset’s fair value. The Company has not recognized any impairment losses through September 30, 2013.

Research and Development Expenses

All research and development costs are charged to expense as incurred.

Income Taxes

The Company’s policy related to accounting for uncertainty in income taxes prescribes a recognition threshold and measurement attribute criteria for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities. As of December 31, 2012, there are no unrecognized tax benefits included in the consolidated balance sheet that would, if recognized, affect the Company’s effective tax rate. The Company has not recognized interest and penalties in the consolidated balance sheets or consolidated statements of operations and comprehensive loss. The Company is subject to U.S. and California taxation. As of December 31, 2012, the Company’s tax years beginning 2005 to date are subject to examination by taxing authorities.

 

7

---

Table of Contents

Convertible Preferred Stock Warrant Liability

The Company has issued freestanding warrants exercisable to purchase shares of its Series A and Series B convertible preferred stock. These warrants were classified as a liability in the accompanying consolidated balance sheets prior to the completion of the IPO, as the terms for redemption of the underlying security were outside the Company’s control. The Series A convertible preferred stock warrants were recorded at fair value using the Black-Scholes option pricing model. The Series B convertible preferred stock warrants were recorded at fair value using a Monte Carlo model. The fair value of all warrants, except as noted below, was remeasured at each financial reporting date using the Black-Scholes option pricing model with any changes in fair value being recognized in other financing income (expense), a component of other income (expense), in the accompanying statements of operations. The Company ceased the remeasurement of the fair value upon exercise of the Series A warrants, and the Series B warrants becoming exercisable for shares of common stock, immediately prior to the completion of the Company’s IPO in July 2013.

Comprehensive Loss

The Company is required to report all components of comprehensive loss, including net loss, in the consolidated financial statements in the period in which they are recognized. Comprehensive loss is defined as the change in equity during a period from transactions and other events and circumstances from nonowner sources, including unrealized gains and losses on investments. Comprehensive gains (losses) have been reflected in the condensed consolidated statements of operations and comprehensive loss for all periods presented.

Net Income (Loss) Per Share

Basic net income (loss) per share is calculated by dividing the net loss by the weighted average number of common shares outstanding during the period. Diluted net loss per share is computed by dividing the net income (loss) by the weighted average number of common shares and common share equivalents outstanding for the period. Common stock equivalents are only included when their effect is dilutive. The Company’s potentially dilutive securities, which include convertible preferred stock, warrants and outstanding stock options under the stock option plan, have been excluded from the computation of diluted net income (loss) per share in the periods in which they would be anti-dilutive.

The following table sets forth the computation of basic and diluted earnings per share:

 

		Three months ended September 30,								Nine months ended September 30,
		2013				2012				2013				2012
Numerator:
Net income (loss) applicable to common stockholders		$	(3,320,781	)		$	(2,584,631	)		$	—			$	(6,314,152	)
Denominator for basic and diluted net income (loss) per share:
Weighted average common shares outstanding for basic and diluted			11,664,328				1,012,117				4,660,027				1,012,117
Net income (loss) per share applicable to common stockholders:
Basic		$	(0.28	)		$	(2.55	)		$	—			$	(6.24	)
Diluted		$	(0.28	)		$	(2.55	)		$	—			$	(6.24	)

The following table sets forth the outstanding potentially dilutive securities that have been excluded in the calculation of diluted net loss per share because to do so would be anti-dilutive.

 

		Three months ended September 30,								Nine months ended September 30,
		2013				2012				2013				2012
Convertible preferred stock			—				9,565,021				—				9,565,021
Warrants to purchase preferred stock-Series A			—				280,675				—				280,675
Common stock warrants			149,704				—				149,704				—
Common stock options			730,590				549,411				730,590				549,411
Common stock subject to repurchase			284,810				176,781				284,810				176,781
Total			1,165,104				10,571,888				1,165,104				10,571,888

 

8

---

Table of Contents

3. Fair Value Measurements

The accounting guidance defines fair value, establishes a consistent framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring or nonrecurring basis. Fair value is defined as an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the accounting guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

 

		Level 1:		Includes financial instruments for which quoted market prices for identical instruments are available in active markets.
		Level 2:		Includes financial instruments for which there are inputs other than quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets with insufficient volume or infrequent transaction (less active markets) or model-driven valuations in which significant inputs are observable or can be derived principally from, or corroborated by, observable market data.
		Level 3:		Includes financial instruments for which fair value is derived from valuation techniques in which one or more significant inputs are unobservable, including management’s own assumptions.

Below is a summary of assets and liabilities measured at fair value as of September 30, 2013 and December 31, 2012.

 

						Fair Value Measurements Using
		September 30, 2013				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets
Money market funds		$	34,521,369			$	34,521,369			$	—			$	—
Corporate debt securities			22,698,842				—				22,698,842				—
Debt securities in government sponsored entities			1,502,715				—				1,502,715				—
Municipal bonds			255,000				—				255,000				—
Total assets		$	58,977,926			$	34,521,369			$	24,456,557			$	—
						Fair Value Measurements Using
		December 31, 2012				Quoted Prices in Active Markets for Identical Assets (Level 1)				Significant Other Observable Inputs (Level 2)				Significant Unobservable Inputs (Level 3)
Assets
Money market funds		$	3,874,153			$	3,874,153			$	—			$	—
Municipal bonds			260,000				—				260,000				—
Corporate debt securities			3,729,473				—				3,729,473				—
Total assets		$	7,863,626			$	3,874,153			$	3,989,473			$	—
Liabilities
Convertible preferred stock warrant liability		$	160,345			$	—			$	—			$	160,345
Total liabilities		$	160,345			$	—			$	—			$	160,345

The Company’s marketable securities, consisting principally of debt securities, are classified as available-for-sale, are stated at fair value and consist of Level 2 financial instruments in the fair value hierarchy. The Company determines the fair value of its debt security holdings based on pricing from a service provider. The service provider values the securities based on using market prices from a variety of industry-standard independent data providers. Such market prices may be quoted prices in active markets for identical assets (Level 1 inputs) or pricing determined using inputs other than quoted prices that are observable either directly or indirectly (Level 2 inputs), such as, yield curve, volatility factors, credit spreads, default rates, loss severity, current market and contractual prices for the underlying instruments or debt, broker and dealer quotes, as well as other relevant economic measures.

 

9

---

Table of Contents

The fair value of the convertible preferred stock warrant liability was determined based on “Level 3” inputs and utilized the Black-Scholes option pricing model for the Series A convertible preferred stock warrants. The Series B convertible preferred stock warrants utilized a Monte Carlo model. The warrant liabilities were marked to market before converting to equity at the IPO. The following table presents activity for the convertible preferred stock warrant liability measured at fair value using significant unobservable Level 3 inputs during the years ended December 31, 2012 and the nine months ended September 30, 2013.

 

		Fair Value Measurements at Reporting Date Using Significant Unobservable Inputs (Level 3)
Balance at December 31, 2011		$	68,786
Changes in fair value reflected as other financing expense			91,559
Balance at December 31, 2012			160,345
Issuance of preferred stock warrants			625,679
Changes in fair value reflected as other financing expense			3,457,184
Conversion to equity at IPO			(4,243,208	)
Balance at September 30, 2013		$	—

The fair value of the convertible promissory notes was determined based on “Level 3” inputs and valued the notes utilizing an estimated cost of debt from publicly available information on issuances of high yield fixed income securities issued by comparable companies. The Company concluded that a 15% discount rate was appropriate, resulting in an initial fair value for the notes of approximately $970,000. The discount was accreted to interest expense through the Company’s IPO and was accreted completely at IPO as the notes plus accrued interest converted to common stock at IPO. The following table presents activity for the convertible promissory notes measured at fair value using significant unobservable Level 3 inputs during the years ended December 31, 2012 and the nine months ended September 30, 2013.

 

 

		Fair Value Measurements at Reporting Date Using Significant Unobservable Inputs (Level 3)
Balance at December 31, 2012		$	—
Issuance of convertible promissory notes			970,000
Accretion of debt discount to interest expense			31,439
Conversion to equity at IPO			(1,001,439	)
Balance at September 30, 2013		$	—

4. Investments

The Company invests its excess cash in money market funds and debt instruments of financial institutions, corporations, and municipal bonds. The following tables summarize the Company’s marketable securities:

 

As of September 30, 2013		Maturity (in years)				Amortized Cost				Unrealized Gains				Unrealized Losses				Estimated fair value
Corporate debt securities			1 or less			$	22,687,884			$	10,958			$	—			$	22,698,842
Municipal bonds			1 or less				255,000				—				—				255,000
Debt securities in government sponsored entities			1-2 years				1,501,941				774				—				1,502,715
Total						$	24,444,825			$	11,732			$	—			$	24,456,557

 

10

---

Table of Contents

5. Property and Equipment

Property and equipment consist of the following:

 

		Useful Life In Years				September 30, 2013				December 31, 2012
Furniture and fixtures			4			$	112,876			$	112,876
Computer equipment and office equipment			4				95,199				95,199
Leasehold improvements			4				3,645				3,645
							211,720				211,720
Less accumulated depreciation and amortization							(189,915	)			(182,116	)
						$	21,805			$	29,604

6. Notes Payable

In July 2010, the Company entered into a $1,000,000 promissory note payable to Pfizer Inc. The note bears interest at 7% per annum which is paid quarterly and matures on July 29, 2020. The note payable prohibits the Company from paying cash dividends and is subject to acceleration upon specified events of default as defined in the agreement including the failure to notify Pfizer of certain material adverse events. In July 2013, the note payable to Pfizer was amended to become convertible into shares of the Company’s common stock following the completion of the IPO, at the option of the holder, at a price per share equal to the fair market value of the common stock on the date of conversion.

In May 2013, the Company entered into a note and warrant purchase agreement with certain existing investors pursuant to which it sold, in a private placement, an aggregate of $1.0 million of convertible promissory notes (the 2013 Notes), and issued warrants exercisable to purchase 1,124,026 shares of Series B Preferred Stock (the 2013 Warrants). The 2013 Notes accrued interest at a rate of 6% per annum and were due and payable on the earlier of (1) any date after November 30, 2013 upon which holders of 75% of the outstanding principal amount of all such 2013 Notes demand repayment, or (2) the occurrence of a change of control of the Company, subject in each case to their earlier conversion in the event the Company completed a qualified initial public offering or private placement of debt and/or equity. The 2013 Notes did not provide for any potential adjustments to the stated conversion rates other than in the event of stock splits, stock dividends and recapitalizations. The conversion of the 2013 Notes in the event of a qualified initial public offering or private placement of equity was deemed to be the predominant settlement mechanism. As this predominant settlement mechanism provided for the settlement of a fixed monetary amount in a variable number of equity instruments, the Company concluded that it was appropriate to recognize the 2013 Notes at fair value. The Company valued the 2013 Notes utilizing an estimated cost of debt from publicly available information on issuances of high yield fixed income securities issued by comparable companies. The Company concluded that a 15% discount rate was appropriate, resulting in an initial fair value for the 2013 Notes of approximately $970,000. Upon completion of the IPO, the 2013 Notes plus accrued interest automatically converted into 91,948 shares of common stock.

The 2013 Warrants were exercisable for an aggregate of 1,124,026 shares of Series B Preferred Stock at an exercise price of $0.90 per share. Upon completion of the IPO, the 2013 Warrants became exercisable for an aggregate of 136,236 shares of common stock at an exercise price of $7.43 per share. The 2013 Warrants will expire on May 30, 2018. The 2013 Warrants were initially accounted for as liabilities with changes in fair value recognized within the consolidated statement of operations. The Company determined that the initial value of the 2013 Warrants was $506,000. The 2013 Warrants were valued utilizing a Monte Carlo simulation of various weighted scenarios. Following the IPO, the 2013 Warrants were reclassified into equity at their fair value at the time of the completion of the IPO.

The valuation at the issuance of the 2013 Notes and 2013 Warrants resulted in a deemed distribution in the amount of $474,561 accounted for as a reduction in net income attributable to common stockholders.

In July 2013, the Company entered into a loan and security agreement, (the Credit Facility) with Oxford Finance LLC and Silicon Valley Bank (the Lenders). The Credit Facility provided funding for an aggregate principal amount of up to $15.0 million. The first term loan of the Credit Facility was funded in July 2013 in the amount of $1.0 million. On September 25, 2013, the Company prepaid the outstanding advances under the Credit Facility. Accordingly, the Credit Facility was terminated on September 25, 2013. In connection with the funding of the first term loan under the Credit Facility, the Company issued warrants to the Lenders to purchase up to an aggregate of 111,112 shares of Series B convertible preferred stock at an exercise price of $0.90 per share (Lender Warrants). The Lender Warrants will expire on July 3, 2023. The Lender Warrants were initially accounted for as liabilities with the changes in fair value recognized within the consolidated statement of operations.

 

11

---

Table of Contents

The Lender Warrants were initially valued at $119,679, and such amount was recognized as additional expense. Upon completion of the IPO, the Lender Warrants became exercisable for an aggregate of 13,468 shares of common stock at an exercise price of $7.43 per share. Following the IPO, the Lender Warrants were reclassified into equity at their fair value at the time of the completion of the IPO.

7. Stockholders’ Equity (Deficit)

Common Stock

During 2005, the Company sold 727,273 shares of common stock to founders for approximately $6,000. During 2006, the Company sold 181,818 shares of common stock to founders for approximately $45,000, subject to certain restrictions that have since been released.

In July 2013, the Company implemented a 1-for-8.25 reverse stock split of its outstanding common stock. The accompanying condensed consolidated financial statements give effect to the reverse split for all periods presented.

In July 2013, the Company completed the IPO of 6,000,000 shares of common stock at an offering price of $11.00 per share. The Company received net proceeds of approximately $59.0 million, after deducting underwriting discounts, commissions and offering-related transaction costs.

Convertible Preferred Stock

Between August 2005 and July 2006, the Company borrowed from certain officers and investors an aggregate principal amount of $1,200,000 under convertible promissory notes. The convertible promissory notes had an annual interest rate of 8% and a conversion premium on principal and accrued interest of 15%. The principal, accrued interest and conversion premium under the convertible promissory notes converted into shares of Series A convertible preferred stock (Series A Preferred Stock) in October 2006, in connection with the initial closing of the Series A Preferred Stock financing.

During 2006, the Company entered into agreements with the founding officers and several investors who collectively purchased 10,160,885 shares of Series A Preferred Stock at $0.75 per share for $5,500,000 in cash, the conversion of the bridge financing noted above, plus related accrued interest and conversion premium of $261,439, and the issuance of preferred stock to employees of approximately $659,224 for services (Initial Closing). Additionally, the Company issued 333,333 shares of the Series A Preferred Stock in satisfaction of its initial license payment to Roche Palo Alto LLC and F. Hoffman-La Roche Ltd. (collectively, Roche) (Note 8).

In May 2007, the Company closed the second round of its Series A Preferred Stock financing, providing the Company with $22,000,000 in gross proceeds from the issuance of an additional 29,333,334 shares of Series A Preferred Stock (Second Closing). Additionally, the Company’s Board of Directors determined that the Company had obtained satisfactory completion of certain preclinical studies of its product candidate, which was licensed from Roche, which triggered an additional $3,500,000 payment in cash and $2,000,000, in the form of the issuance of an additional 2,666,666 shares of Series A Preferred Stock to Roche.

The holders of the Series A Preferred Stock were entitled to receive noncumulative dividends at a rate of $0.06 per share per annum. The Series A Preferred Stock dividends were payable when and if declared by the Company’s Board of Directors. As of September 30, 2013, the Company’s Board of Directors had not declared any dividends. The Series A Preferred Stock dividends were payable in preference and in priority to any dividends on common stock.

Included in the terms of the Series A Preferred Stock agreement were certain rights granted to the holders of the Series A Preferred Stock issued in the Initial Closing which obligated the Company to deliver additional shares of Series A Preferred Stock at a specified price in the future at the potential Second Closing based on the achievement of a milestone or at the option of the holders of the Series A Preferred Stock (the Tranche Right). The Series A Preferred Stock, based on its “deemed liquidation” terms, was classified outside of stockholder’s deficit. Accordingly, the Tranche Right to purchase additional shares was valued and classified as a liability in 2006 and 2007. The carrying value was adjusted at each reporting date for any material changes in its estimated fair value. The estimated fair value was determined using a valuation model which considered the probability of achieving a milestone, if any, the entity’s cost of capital, the estimated time period the Tranche Right would be outstanding, consideration received for the instrument with the Tranche Right, the number of shares to be issued to satisfy the Tranche Right, and at what price and any changes in the fair value of the underlying instrument to the Tranche Right. At December 31, 2006, the change in fair value of the Tranche Right was immaterial. In 2007, the change in fair value of the Tranche Right of $530,977 was recorded as other financing expense and the adjusted carrying value of the Tranche Right of $1,827,784 was reclassified to convertible preferred stock on the balance sheet upon the Second Closing in May 2007.

In February 2011, the Company closed the first round of its Series B convertible preferred stock (Series B Preferred Stock) financing, providing the Company with $20,000,000 in gross proceeds from the issuance of 22,222,223 shares of Series B Preferred Stock. Upon the first closing, 5,861,667 shares of Series B Preferred Stock were issued upon the conversion of convertible bridge notes and related accrued interest under the terms of the convertible bridge financing agreement. In March 2011, the Company completed an additional closing to a new investor of its Series B Preferred Stock financing, providing the Company with $7,500,000 in gross proceeds from the issuance of an additional 8,333,334 shares of Series B Preferred Stock.

 

12

---

Table of Contents

The holders of the Series B Preferred Stock were entitled to receive noncumulative dividends at a rate of $0.072 per share per annum. The Series B Preferred Stock dividends were payable when and if declared by the Company’s Board of Directors. As of September 30, 2013, the Company’s Board of Directors had not declared any dividends. The Series B Preferred Stock dividends were payable in preference and in priority to any dividends on common stock and Series A Preferred Stock.

The Series B Preferred Stock, based on its “deemed liquidation” terms, was classified outside of stockholders’ deficit.

On May 30, 2013, 15,576,789 shares of the Company’s convertible preferred stock were converted into 1,557,678 shares of common stock (188,808 shares on a post-reverse split basis) as a result of one preferred stock investor not purchasing a pro rata share of the 2013 Notes. As a result of this transaction, a gain on the extinguishment of preferred stock was recognized as income applicable to common stockholders and an addition to additional paid-in capital in the amount of $11,491,043, which represented the difference between the carrying value of the 15,576,789 shares of convertible preferred stock and the fair value of the 188,808 shares of common stock.

In connection with the IPO in July 2013, all 63,334,653 outstanding shares of convertible preferred stock converted into an aggregate of 7,676,914 shares of common stock.

Warrants

The Company issued warrants to purchase a total of 2,333,320 shares of Series A Preferred Stock in conjunction with a convertible bridge financing in 2010 and issued the 2013 Warrants and Lender Warrants in conjunction with a convertible bridge financing and Credit Facility funding in 2013. The Company initially accounted for the warrants as liabilities because they were exercisable for shares of preferred stock that was classified outside of permanent equity. The convertible preferred stock warrant liability was required to be recorded at fair value at the grant date of the warrants and the carrying value adjusted at each reporting date. The Company revalued the warrants at July 30, 2013 (date of IPO closing) and September 30, 2012, and recorded the change in the value of the warrants of $139,328 for the three months ended September 30, 2013 and $3,457,184 for the nine months ended September 30, 2013 as other financing expense. The Company recorded the change in the value of the warrants of $56,700 for the three months ended September 30, 2012 and $91,793 for the nine months ended September 30, 2012 as other financing expense. The Series A warrants converted to 280,675 shares of common stock as a result of the net exercise of such warrants at the IPO. Upon the completion of the IPO, the 2013 Warrants and the Lender Warrants became exercisable for an aggregate of 149,704 shares of common stock at an exercise price of $7.43 per share. Following the IPO, the 2013 Warrants and Lender Warrants were reclassified into equity at their fair value at the time of the completion of the IPO.

Common Stock

The following shares of common stock are reserved for future issuance at September 30, 2013:

 

Convertible common stock warrants			149,704
Stock options issued and outstanding			730,590
Authorized for future option grants			827,278
			1,707,572

The following table summarizes the Company’s stock option activity under all stock option plans for the nine months ended September 30, 2013:

 

 

		Total Options				Weighted- Average Exercise Price
Balance at December 31, 2012			690,223			$	0.80
Granted			226,935				9.43
Exercised			(174,447	)			0.24
Cancelled			(12,121	)			0.09
Balance at September 30, 2013			730,590			$	3.63

The Company recorded stock-based compensation of $75,463 and $28,677 for the three months ended September 30, 2013 and 2012, respectively, and $101,379 and $105,751 for the nine months ended September 30, 2013 and 2012, respectively.

 

13

---

Table of Contents

8. Commitments

The Company leases certain office space under a noncancelable operating lease with terms through June 30, 2014. The rent expense for the three months ended September 30, 2013 and 2012 was $45,003 and $38,514, respectively. The rent expense for the nine months ended September 30, 2013 and 2012 was $122,032 and $114,202, respectively. Future minimum payments under the aforementioned noncancelable operating lease total $132,390.

In July 2010, the Company entered into a stock purchase agreement with Pfizer, pursuant to which the Company acquired all of the outstanding stock of Idun. Under the agreement, the Company may be required to make payments to Pfizer totaling $18.0 million upon the achievement of specified regulatory milestones.

9. Spin-off of Idun Pharmaceuticals, Inc.

In January 2013, the Company spun off its subsidiary Idun to the Company’s stockholders. Prior to the spin-off, rights relating to emricasan were distributed to the Company by Idun pursuant to a distribution agreement. The spin-off was conducted as a dividend of all of the outstanding capital stock of Idun to the Company’s stockholders. As a result, the Company no longer held any capital stock of Idun. In connection with the spin-off, the Company contributed $500,000 to Idun to provide for Idun’s initial working capital requirements. The assets remaining in Idun at the time of the spin-off consisted of cash, intellectual property rights and license and collaboration agreements unrelated to emricasan. Other than the cash of $500,000, none of the assets held by Idun had any historical carrying value at the time of the spin-off. As a result, the Company recognized a reduction in equity as a result of the spin-off of $500,000, representing the carrying value of Idun in the Company’s consolidated financial statements at the time of the spin-off.

 

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis and the interim financial statements included in this quarterly report on Form 10-Q should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2012 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our final prospectus filed with the Securities and Exchange Commission, or SEC, on July 25, 2013, relating to our Registration Statement on Form S-1, as amended (File No. 333-189305), for our initial public offering.

Forward-Looking Statements

This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. All statements other than statements of historical facts contained in this quarterly report, including statements regarding our future results of operations and financial position, business strategy, prospective products, product approvals, research and development costs, timing and likelihood of success, plans and objectives of management for future operations, and future results of anticipated products, are forward-looking statements. These statements involve known and unknown risks, uncertainties and other important factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “expect,” “plan,” “anticipate,” “could,” “intend,” “target,” “project,” “contemplates,” “believes,” “estimates,” “predicts,” “potential” or “continue” or the negative of these terms or other similar expressions. The forward-looking statements in this quarterly report are only predictions. We have based these forward-looking statements largely on our current expectations and projections about future events and financial trends that we believe may affect our business, financial condition and results of operations. These forward-looking statements speak only as of the date of this quarterly report and are subject to a number of risks, uncertainties and assumptions, including those described in Part II, Item 1A, “Risk Factors.” The events and circumstances reflected in our forward-looking statements may not be achieved or occur and actual results could differ materially from those projected in the forward-looking statements. Moreover, we operate in an evolving environment. New risk factors and uncertainties may emerge from time to time, and it is not possible for management to predict all risk factors and uncertainties. Except as required by applicable law, we do not plan to publicly update or revise any forward-looking statements contained herein, whether as a result of any new information, future events, changed circumstances or otherwise.

Overview

We are a biotechnology company focused on the development and commercialization of novel medicines to treat liver disease. We are developing our lead compound, emricasan, for the treatment of patients with chronic liver disease and acute exacerbations of chronic liver disease. To date, emricasan has been studied in over 500 subjects in ten clinical trials. In a randomized Phase 2b clinical trial, emricasan demonstrated a statistically significant, consistent, rapid and sustained reduction in elevated levels of two key biomarkers of inflammation and cell death, alanine aminotransferase, or ALT, and cleaved Cytokeratin 18, or cCK18, respectively, both of which are implicated in the severity and progression of liver disease. Our initial development strategy targets indications for emricasan with high unmet clinical need and orphan patient populations, such as patients with acute-on-chronic liver failure, or ACLF,

 

 

14

---

Table of Contents

and chronic liver failure, or CLF. Although we plan to focus primarily on the development of emricasan for ACLF and CLF, we may also evaluate the compound in patients who have developed non-alcoholic steatohepatitis, or NASH as well as liver fibrosis post-orthotopic liver transplant due to Hepatitis C virus infection, or HCV-POLT.

We plan to study emricasan in patients with established liver cirrhosis and decompensated liver disease with our first opportunity for regulatory approval expected to be in the ACLF patient population. Our planned trials in ACLF will evaluate whether emricasan can halt the progression of decompensation to multi-organ failure or death in an acutely decompensating cirrhotic patient population. Our planned trials in CLF will assess whether emricasan can stabilize decompensation and provide patients with chronic decompensation additional time to obtain a liver transplant. Our clinical development plan for emricasan includes a Phase 2b clinical trial in ACLF patients and a Phase 2b clinical trial in CLF patients. We recently initiated the Phase 2b ACLF trial and plan to initiate the Phase 2b CLF trial in the second half of 2014.

While we remain on track with our clinical development plans for emricasan in ACLF and CLF, recent clinical trial results presented at the AASLD Liver Meeting^® showing that the administration of sofosbuvir, a new HCV antiviral being developed by Gilead Sciences, in combination with ribavirin in patients who have developed liver fibrosis post-orthotopic liver transplant due to Hepatitis C virus infection, or HCV-POLT, was well-tolerated and achieved a preliminary sustained virologic response rate of 77% after four weeks of dosing has caused us to revise our clinical development strategy in the HCV-POLT patient population. We have decided to delay the initiation of our previously planned Phase 2b/3 clinical trial in HCV-POLT patients (designated a Phase 3 registration study in the European Union and a Phase 2b study in the United States) pending further analysis of the impact of the new HCV antiviral data on our ability to recruit and maintain patient compliance during the proposed two years of dosing with emricasan. We still believe that this well-characterized patient population can be an important development opportunity for emricasan at some time in the future.

In order to continue the development of emricasan as an antifibrogenic treatment, and consistent with our analysis of the outcome of the AASLD – FDA Workshop on “Trial Designs and Endpoints for Liver Disease Secondary to Nonalcoholic Fatty Liver Disease (NAFLD)” held in September 2013, we are considering initiating studies in patients whose liver fibrosis is secondary to NAFLD. Emricasan has demonstrated activity in preclinical models of both NASH and NAFLD. In models of NASH, emricasan inhibited apoptosis, fibrosis and inflammation associated with experimental NASH. In a model of NAFLD, emricasan reduced inflammation of adipose tissue, resolved hepatic steatosis and improved metabolic parameters reduced fasting glucose and insulin levels. We believe that these preclinical data provide support for evaluating emricasan in patients with NASH and NAFLD.

We previously conducted the majority of our activities related to emricasan through our wholly-owned subsidiary, Idun Pharmaceuticals, Inc., or Idun, which we acquired from Pfizer Inc. in August 2010. In January 2013, the assets and rights related to emricasan were distributed from Idun to us for no consideration, at which time we spun off Idun, which became an independent company owned by our stockholders at that time. The following information is presented on a consolidated basis to include the accounts of Idun. All intercompany transactions and balances are eliminated in consolidation.

Since our inception, our primary activities have been organizational activities, including recruiting personnel, conducting research and development, including clinical trials and raising capital. Prior to our initial public offering in July 2013, we funded our operations primarily through sales of preferred stock and convertible promissory notes. From inception through September 30, 2013, we have received net proceeds of $61.0 million from such sales. In July 2013, we completed our initial public offering of 6,000,000 shares of common stock at an offering price of $11.00 per share. We received net proceeds of approximately $59.0 million from our initial public offering, after deducting underwriting discounts, commissions and offering-related transaction costs.

We have no products approved for sale, we have not generated any revenues to date and we have incurred significant operating losses since our inception. We have never been profitable and have incurred consolidated net losses of approximately $12.0 million and $8.7 million in the years ended December 31, 2011 and 2012, respectively, and $3.3 million and $10.5 million for the three and nine months ended September 30, 2013, respectively. As of September 30, 2013, we had an accumulated deficit of $69.3 million.

We expect to continue to incur significant operating losses and negative cash flows from operating activities for the foreseeable future as we continue the clinical development of emricasan and seek regulatory approval for and, if approved, pursue eventual commercialization of emricasan. As of September 30, 2013, we had cash, cash equivalents and marketable securities of approximately $59.6 million. To fund further operations, we will need to raise additional capital. We may obtain additional financing in the future through the issuance of our common stock in future public offerings, through other equity or debt financings or through collaborations or partnerships with other companies. Although it is difficult to predict future liquidity requirements, we believe that our existing cash, cash equivalents and marketable securities, together with interest thereon, including funds raised in the initial public offering, will be sufficient to fund our operations for at least the next 18 months, including the completion of our Phase 2b ACLF trial and our planned Phase 2b CLF trial. We will need to raise additional funds to complete additional clinical trials of emricasan, to fund regulatory filings for emricasan in the United States and the European Union and for potential commercialization of emricasan. However, successful transition to profitability is dependent upon achieving a level of revenues adequate to support our cost structure. We cannot assure you that we will ever be profitable or generate positive cash flow from operating activities and, unless and until we do, we will need to

 

15

---

Table of Contents

raise substantial additional capital through debt or equity financings or through collaborations or partnerships with other companies. We may not be able to raise additional capital on terms acceptable to us, or at all, and any failure to raise capital as and when needed could have a material adverse effect on our results of operations, financial condition and our ability to execute on our business plan.

Financial Overview

Revenues

We currently have no products approved for sale, and we have not generated any revenues to date. We have not submitted any drug candidate for regulatory approval. In the future, we may generate revenues from a combination of milestone payments, reimbursements, and royalties in connection with any future collaboration we may enter into with respect to emricasan, as well as product sales from emricasan. However, we do not expect to receive revenues unless and until we receive approval for emricasan or potentially enter into collaboration agreements for emricasan. If we fail to achieve clinical success in the development of emricasan in a timely manner and/or obtain regulatory approval for this drug candidate, our ability to generate future revenues would be materially adversely affected.

Research and Development Expenses

The majority of our operating expenses to date have been incurred in research and development activities. In late 2011, we ceased clinical development of a drug candidate, CTS-1027, which we licensed from Roche Palo Alto LLC and F. Hoffman-La Roche Ltd., or collectively Roche, in 2006. In early 2012, the rights to this drug candidate reverted to Roche. Research and development expenses through 2011 were primarily devoted to this drug candidate. Starting in late 2011, research and development expenses have been focused on the development of emricasan. Since acquiring emricasan in 2010, we have incurred approximately $12.9 million in the development of emricasan through September 30, 2013. Our business model is currently focused on the broad development of emricasan in various liver diseases and is dependent upon our continuing to conduct research and a significant amount of clinical development. Our research and development expenses consist primarily of:

 

•

expenses incurred under agreements with contract research organizations, or CROs, investigative sites and consultants that conduct our clinical trials and our preclinical studies;

 

•

employee-related expenses, which include salaries and benefits;

 

•

the cost of finalizing our chemistry, manufacturing and controls, or CMC, capabilities and providing clinical trial materials;

 

•

facilities, depreciation and allocated operating expenses; and

 

•

costs associated with other research activities and regulatory approvals.

Research and development costs are expensed as incurred.

At this time, due to the inherently unpredictable nature of preclinical and clinical development, we are unable to estimate with any certainty the costs we will incur in the continued development of emricasan. Clinical development timelines, the probability of success and development costs can differ materially from expectations.

We are currently focused on advancing emricasan in multiple indications and our future research and development expenses will depend on its clinical success. In addition, we cannot forecast with any degree of certainty whether emricasan will be the subject of future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and capital requirements.

Research and development expenditures will continue to be significant and will increase as we continue clinical development of emricasan over at least the next several years. We expect to incur significant development costs as we conduct our planned Phase 2b and Phase 3 clinical trials of emricasan, subject to receiving input from regulatory authorities.

The costs of clinical trials may vary significantly over the life of a project owing to factors that include but are not limited to the following:

 

•

per patient trial costs;

 

•

the number of patients that participate in the trials;

 

•

the number of sites included in the trials;

 

•

the countries in which the trial is conducted;

 

•

the length of time required to enroll eligible patients;

 

•

the number of doses that patients receive;

 

•

the drop-out or discontinuation rates of patients;

 

16

---

Table of Contents

•

potential additional safety monitoring or other studies requested by regulatory agencies;

 

•

the duration of patient follow-up; and

 

•

the efficacy and safety profile of the drug candidate.

We do not expect emricasan to be commercially available, if at all, for at least the next several years.

General and Administrative Expenses

General and administrative expenses consist principally of salaries and related costs for personnel in executive, finance, and business development functions. Other general and administrative expenses include facility costs, patent filing and maintenance costs, and professional fees for legal, consulting, auditing and tax services.

We anticipate that our general and administrative expenses will increase in future periods, reflecting an expanding infrastructure and increased professional fees associated with being a public reporting company.

In addition, if emricasan receives regulatory approval, we expect to incur increased expenses associated with building a sales and marketing team. Some expenses may be incurred prior to receiving regulatory approval of emricasan. We do not expect to receive any such regulatory approval for at least the next several years.

Interest Income

Interest income consists primarily of interest income earned on our cash and cash equivalents as well as our marketable securities.

Interest Expense

Interest expense consists of coupon interest on our $1.0 million promissory note payable to Pfizer Inc., interest accrued on the convertible promissory notes payable to certain existing investors issued in May 2013, and interest accrued pursuant to the loan and security agreement, or the credit facility, with Oxford Finance LLC, as collateral agent and a lender, or Oxford, and certain other lenders party thereto from time to time, including Silicon Valley Bank, through our prepayment of the outstanding advances under the credit facility in September 2013.

Other Income (Expense)

Other income primarily includes a one-time, non-operating transaction associated with the receipt of a federal investment tax credit in 2010.

Other Financing Expense

Other financing expense consists of the revaluation of our convertible preferred stock warrants issued in conjunction with our 2010 and 2013 bridge note financings.

Critical Accounting Policies and Significant Judgments and Estimates

Our management’s discussion and analysis of 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, or GAAP. The preparation of these 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 the reported revenues and expenses during the reporting periods. These items are monitored and analyzed by us for changes in facts and circumstances, and material changes in these estimates could occur in the future. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Changes in estimates are reflected in reported results for the period in which they become known. Actual results may differ materially from these estimates under different assumptions or conditions.

While our significant accounting policies are more fully described in Note 2 to our condensed consolidated financial statements appearing elsewhere in this quarterly report on Form 10-Q, we believe that the following accounting policies are the most critical for fully understanding and evaluating our financial condition and results of operations.

Accrued Research and Development Expenses

As part of the process of preparing our consolidated financial statements, we are required to estimate our accrued research and development expenses. This process involves reviewing contracts and purchase orders, reviewing the terms of our vendor agreements, communicating with our applicable personnel to identify services that have been performed on our behalf, and estimating the level of

 

17

---

Table of Contents

service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual cost. The majority of our service providers invoice us monthly in arrears for services performed. We make estimates of our accrued expenses as of each balance sheet date in our consolidated financial statements based on facts and circumstances known to us at that time.

Examples of estimated accrued research and development expenses include:

 

•

fees paid to CROs in connection with clinical studies;

 

•

fees paid to investigative sites in connection with clinical studies;

 

•

fees paid to vendors in connection with preclinical development activities; and

 

•

fees paid to vendors related to product manufacturing, development and distribution of clinical supplies.

We base our expenses related to clinical studies on our estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and CROs that conduct and manage clinical studies on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract, and may result in uneven payment flows and expense recognition. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If the actual timing of the performance of services or the level of effort varies from our estimate, we adjust the accrual accordingly. Our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in our reporting changes in estimates in any particular period. We have not experienced any significant adjustments to our estimates to date. Clinical trial activities were minimal for the years ended December 31, 2011 and 2012, and the nine months ended September 30, 2013.

Share-Based Compensation

We account for share-based compensation by measuring and recognizing compensation expense for all share-based payments made to employees and directors based on estimated grant date fair values. We use the straight-line method to allocate compensation cost to reporting periods over each optionee’s requisite service period, which is generally the vesting period. We estimate the fair value of our share-based awards to employees and directors using the Black-Scholes option pricing model. The Black-Scholes model requires the input of subjective assumptions, including the risk-free interest rate, expected dividend yield, expected volatility, expected term and the fair value of the underlying common stock on the date of grant, among other inputs.

We account for stock options granted to non-employees, which primarily consists of members of our board of directors, using the fair value approach. Stock options granted to non-employees are subject to periodic revaluation over their vesting terms.

Convertible Preferred Stock Warrant Liability

We have issued freestanding warrants exercisable for shares of our Series A and Series B convertible preferred stock. These warrants were classified as a liability in the accompanying condensed consolidated balance sheets prior to the completion of our initial public offering in July 2013, as the terms for redemption of the underlying security were outside our control. The Series A warrants were recorded at fair value using the Black-Scholes option pricing model. The Series B warrants were recorded at fair value using a Monte Carlo model. The fair value of all warrants, except as noted below, was remeasured at each financial reporting date using the Black-Scholes option pricing method with any changes in fair value being recognized in other financing income (expense), a component of other income (expense), in the accompanying condensed consolidated statements of operations. We ceased the remeasure of the fair value of the convertible warrant liability upon the exercise of the Series A warrants and conversion of the Series B warrants to common stock warrants, which occurred immediately prior to the completion of our initial public offering on July 30, 2013. Subsequent to such exercise and conversion, the warrants are classified as a component of stockholders’ equity and are no longer subject to remeasurement.

JOBS Act

In April 2012, the JOBS Act was signed into law. The JOBS Act contains provisions that, among other things, reduce certain reporting requirements for an “emerging growth company.” As an “emerging growth company,” we are electing not to take advantage of the extended transition period afforded by the JOBS Act for the implementation of new or revised accounting standards, and as a result, we will comply with new or revised accounting standards on the relevant dates on which adoption of such standards is required for non-emerging growth companies. Section 107 of the JOBS Act provides that our decision not to take advantage of the extended transition period is irrevocable. In addition, we are in the process of evaluating the benefits of relying on the other exemptions and reduced reporting requirements provided by the JOBS Act. Subject to certain conditions set forth in the JOBS Act, if as an “emerging growth company” we choose to rely on such exemptions, we may not be required to, among other things, (i) provide an auditor’s attestation report on our system of internal controls over financial reporting pursuant to Section 404, (ii) provide all of the compensation disclosure that may be required of non-emerging growth public companies under the Dodd-Frank Wall Street Reform and Consumer Protection Act, (iii) comply with any requirement that may be adopted by the Public Company Accounting Oversight

 

18

---

Table of Contents

Board regarding mandatory audit firm rotation or a supplement to the auditor’s report providing additional information about the audit and the financial statements (auditor discussion and analysis), and (iv) disclose certain executive compensation-related items such as the correlation between executive compensation and performance and comparisons of the Chief Executive Officer’s compensation to median employee compensation. These exemptions will apply for a period of five years following the completion of our initial public offering or until we no longer meet the requirements of being an “emerging growth company,” whichever is earlier.

Results of Operations

Comparison of the Three Months Ended September 30, 2013 and 2012

Research and Development Expenses. Research and development expenses were $1.9 million and $1.8 million in the three months ended September 30, 2013 and 2012, respectively. The increase was primarily due to increased personnel and travel costs associated with development activities.

General and Administrative Expenses. General and administrative expenses were $1.1 million and $0.7 million in the three months ended September 30, 2013 and 2012, respectively. The increase was primarily due to additional personnel costs and costs associated with being a public company, including increased insurance premiums, legal, accounting, and board of directors expenses.

Changes in components of Other Income (Expense) were as follows:

Interest Income. Interest income was $8,000 and $6,000 for the three months ended September 30, 2013 and 2012, respectively.

Interest Expense. Interest expense was $204,000 and $18,000 for the three months ended September 30, 2013 and 2012. The increase was primarily due to interest and expenses associated with the aggregate of $1.0 million of convertible promissory notes we issued in May 2013 and the Credit Facility funded in July 2013.

Other Income (Expense). Other income was $8,000 for the three months ended September 30, 2013, as compared to other expense of $4,000 for the same period in 2012 caused by currency fluctuation in the conversion of U.S. dollars to pounds sterling.

Other Financing Expense. Other financing expense for the three months ended September 30, 2013 was $139,000, while other financing expense for the same period in 2012 was $57,000. Other financing expense for the two periods represent the revaluation of warrants to purchase Series A convertible preferred stock issued in 2010 as well as the valuations of warrants to purchase Series B convertible preferred stock we issued in May and July 2013.

Comparison of the Nine Months Ended September 30, 2013 and 2012

Research and Development Expenses. Research and development expenses were $4.0 million in each of the nine months ended September 30, 2013 and 2012.

General and Administrative Expenses. General and administrative expenses were $2.5 million and $2.2 million for the nine months ended September 30, 2013 and 2012, respectively. The increase was primarily due to additional personnel costs and costs associated with being a public company, including increased insurance premiums, legal, accounting, and board of directors expenses.

Changes in components of Other Income (Expense) were as follows:

Interest Income. Interest income was $8,000 and $22,000 for the nine months ended September 30, 2013 and 2012, respectively.

Interest Expense. Interest expense was $418,000 and $53,000 for the nine months ended September 30, 2013 and 2012, respectively. The increase was primarily due to interest and expenses associated with the aggregate of $1.0 million of convertible promissory notes we issued in May 2013 and the Credit Facility funded in July 2013.

Other Income (Expense). Other expense was $7,000 for the nine months ended September 30, 2013 and $100 for the same period in 2012. The increase was primarily due to currency fluctuation in the conversion of U.S. dollars to pounds sterling.

Other Financing Expense. Other financing expense for the nine months ended September 30, 2013 was $3.6 million, while other financing expense for the same period in 2012 was $92,000. Other financing expense for the two periods represent the revaluation of warrants to purchase Series A convertible preferred stock we issued in 2010 as well as the valuations of warrants to purchase Series B convertible preferred stock we issued in May and July 2013. The increase in expense for the nine months ended September 30, 2013 was a result of the increase in the Company’s stock price. Additionally, the write off of the debt discount associated with our bridge note financing is included in other financing expense for the nine months ended September 30, 2013.

 

19

---

Table of Contents

Liquidity and Capital Resources

We have incurred losses since inception and negative cash flows from operating activities and, as of September 30, 2013, we had an accumulated deficit of $69.3 million. We anticipate that we will continue to incur net losses for the foreseeable future as we continue the development and potential commercialization of emricasan and incur additional costs associated with being a public company.

Prior to our initial public offering in July 2013, we funded our operations primarily through private placements of equity and convertible debt securities. In July 2013, we completed our initial public offering of 6,000,000 shares of common stock at an offering price of $11.00 per share. We received net proceeds of approximately $59.0 million, after deducting underwriting discounts, commissions and offering-related transaction costs. At September 30, 2013, we had cash, cash equivalents and marketable securities of approximately $59.6 million. To fund further operations, we will need to raise additional capital. We plan to continue to fund losses from operations and capital funding needs through future debt and equity financing, as well as potential additional collaborations. The sale of additional equity or convertible debt could result in additional dilution to our stockholders. The incurrence of indebtedness would result in debt service obligations and could result in operating and financing covenants that would restrict our operations. No assurances can be provided that financing will be available in the amounts we need or on terms acceptable to us, if at all. If we are not able to secure adequate additional funding we may be forced to make reductions in spending, extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm our business, results of operations, and future prospects.

In May 2013, we issued $1.0 million in aggregate principal amount of convertible promissory notes, which notes automatically converted into 91,948 shares of our common stock in connection with the completion of our initial public offering.

In July 2013, we entered into the credit facility. The credit facility provided funding for an aggregate principal amount of up to $15.0 million. The first term loan of the credit facility was funded in July 2013 in the aggregate principal amount of $1.0 million. On September 25, 2013, we prepaid the outstanding advances under the credit facility. Pursuant to the terms of the credit facility, Conatus prepaid the outstanding principal balance of $1.0 million plus accrued and unpaid interest, a prepayment fee of $30,000, a final payment of $50,000 and the collateral agent’s legal fees incurred with respect to the prepayment. The credit facility was terminated on September 25, 2013.

 

20

---

Table of Contents

The following table sets forth a summary of the net cash flow activity for each of the periods set forth below:

 

		Nine Months Ended September 30,
		2013				2012
		(unaudited)
Net cash used in operating activities		$	(7,553,259	)		$	(6,477,342	)
Net cash provided by (used in) investing activities			(20,498,839	)			6,945,042
Net cash provided by financing activities			59,151,398				14,585
Net increase in cash and cash equivalents		$	31,099,300			$	482,285

Net cash used in operating activities was $7.6 million for the nine months ended September 30, 2013 and $6.5 million for the same period in 2012. The primary use of cash was to fund our operations related to the development of our drug candidates in each of these periods.

Net cash used in investing activities was $20.5 million and net cash provided by investing activities was $6.9 million for the nine months ended September 30, 2013 and 2012, respectively. Net cash used in investing activities during the period in 2013 consisted primarily of cash spent to purchase marketable securities. Net cash provided by investing activities during the period in 2012 consisted primarily of cash received from the sales and maturities of marketable securities.

Financing activities in the nine months ended September 30, 2013 provided net cash of $59.1 million compared to $15,000 provided during the nine months ended September 30, 2012. Cash provided in 2013 consisted primarily of the proceeds resulting from the initial public offering in July 2013. Cash provided in 2012 consisted of proceeds received from the exercise of stock options in 2012.

Off-Balance Sheet Arrangements

We do not have any off-balance sheet arrangements (as defined by applicable regulations of the Securities and Exchange Commission) that are reasonably likely to have a current or future material effect on our financial condition, results of operations, liquidity, capital expenditures or capital resources.

 

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

Interest Rate Risk

Our cash, cash equivalents and marketable securities as of September 30, 2013 consisted of cash, money market funds, municipal bonds and corporate debt securities. We are exposed to market risk related to fluctuations in interest rates and market prices. Our primary exposure to market risk is interest income sensitivity, which is affected by changes in the general level of U.S. interest rates. However, because of the short-term nature of the instruments in our portfolio, a sudden change in market interest rates would not be expected to have a material impact on our financial condition and/or results of operation.

Foreign Currency Exchange Risk

We hold certain payroll related funds in pounds sterling and are therefore subject to fluctuations in foreign currency rates for U.S. dollars and pounds sterling in connection with those funds. To date we have not incurred any material effects from foreign currency changes on those funds. Such fluctuations are recorded in Other Income (Expense).

Inflation Risk

Inflation generally affects us by increasing our cost of labor and clinical trial costs. We do not believe that inflation has had a material effect on our business, financial condition or results of operations during the nine months ended September 30, 2013.

 

ITEM 4.

CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our principal executive officer and principal financial officer, has evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, as of the end of the period covered by this quarterly report on Form 10-Q. Based on such evaluation, our principal executive officer and principal financial officer have concluded that as of such date, our disclosure controls and procedures were effective.

 

21

---

Table of Contents

Inherent Limitations of Internal Controls

Our management, including our principal executive officer and our principal financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of a simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

PART II. OTHER INFORMATION

 

ITEM 1.

LEGAL PROCEEDINGS

We are not currently party to any material legal proceedings.

 

ITEM 1A.

RISK FACTORS

There have been no material changes to the risk factors included in “Item 1A. Risk Factors” in our quarterly report on Form 10-Q for the quarter ended June 30, 2013, filed with the SEC on September 9, 2013, other than the risk factors below.

Risks Related to Our Business and Industry

Our business is dependent on the success of a single drug candidate, emricasan, which will require significant additional clinical testing before we can seek regulatory approval and potentially launch commercial sales.*

Our future success depends on our ability to obtain regulatory approval for, and then successfully commercialize our only drug candidate, emricasan. We have not completed the development of any drug candidates, we currently generate no revenues from sales of any drugs, and we may never be able to develop a marketable drug. Emricasan will require additional clinical and non-clinical development, regulatory review and approval in multiple jurisdictions, substantial investment, access to sufficient commercial manufacturing capacity and significant marketing efforts before we can generate any revenues from product sales. We are not permitted to market or promote emricasan before we receive regulatory approval from the FDA or comparable foreign regulatory authorities, and we may never receive such regulatory approvals. Our clinical development plan for emricasan currently includes a Phase 2b clinical trial in patients with acute-on-chronic liver failure, or ACLF, and a Phase 2b clinical trial in patients with chronic liver failure, or CLF. Our previously planned Phase 2b/3 clinical trial in patients who have developed liver fibrosis post-orthotopic liver transplant due to Hepatitis C virus infection, or HCV-POLT, has been delayed pending our analysis of the impact of HCV antiviral drugs on our ability to carry out the originally proposed two-year dosing study, though we still believe that this well-characterized patient population can be an important development opportunity for emricasan at some time in the future. While the HCV-POLT study is designated a Phase 3 registration study in the European Union, or the EU, and based on feedback from the Committee for Medicinal Products for Human Use, we believe it will support the filing of a marketing authorization application, or MAA, in the EU upon completion, it is designated a Phase 2b study in the United States and we therefore sometimes refer to this trial as the Phase 2b/3 HCV-POLT trial. If we decide to continue with the HCV-POLT trial, we plan to seek further discussions with the FDA to determine if the HCV-POLT trial may be used to support the filing of a new drug application, or NDA, in the United States. We cannot guarantee that regulatory authorities in the EU will agree that our Phase 3 HCV-POLT study will qualify as a single registration study in support of an MAA or that the FDA will recognize the results from the HCV-POLT trial in support of an NDA filing in the United States. We recently initiated the Phase 2b ACLF trial and expect to initiate the Phase 2b CLF trial in the second half of 2014. We previously planned to initiate the Phase 2b/3 HCV-POLT trial in the second half of 2013, prior to our decision to delay such trial as described above. There is no guarantee that these trials will commence or be completed on time or at all, and the FDA or comparable foreign regulatory authorities may disagree with the design or implementation of our clinical trials. Even if such regulatory authorities agree with the design and implementation of our clinical trials, we cannot guarantee you that such regulatory authorities will not change their requirements in the future. In addition, even if the trials are successfully completed, we cannot guarantee that the FDA or foreign regulatory authorities will interpret the results as we do, and more trials could be required before we submit emricasan for approval. To the extent that the results of the trials are not satisfactory to the FDA or foreign regulatory authorities for support of a marketing application, approval of emricasan may be significantly delayed, or we may be required to expend significant additional resources, which may not be available to us, to conduct additional trials in support of potential approval of emricasan.

We cannot anticipate when or if we will seek regulatory review of emricasan for any indication. We have not previously submitted an NDA to the FDA, or similar drug approval filings to comparable foreign authorities. An NDA must include extensive preclinical and clinical data and supporting information to establish the drug candidate’s safety and effectiveness for each desired indication. The NDA must also include significant information regarding the chemistry, manufacturing and controls for the product. Obtaining approval of an NDA is a lengthy, expensive and uncertain process, and may not be obtained. We have not received

 

22

---

Table of Contents

marketing approval for any drug candidate, and we cannot be certain that emricasan will be successful in clinical trials or receive regulatory approval for any indication. If we do not receive regulatory approvals for and successfully commercialize emricasan on a timely basis or at all, we may not be able to continue our operations. Even if we successfully obtain regulatory approvals to market emricasan, our revenues will be dependent, in part, on our ability to commercialize emricasan as well as the size of the markets in the territories for which we gain regulatory approval and have commercial rights. If the markets for the treatment of ACLF, CLF or HCV-POLT are not as significant as we estimate, our business and prospects will be harmed.

Clinical drug development involves uncertain outcomes, and results of earlier studies and trials may not be predictive of future trial results.

Clinical testing is expensive and can take many years to complete, and its outcome is inherently uncertain. Failure can occur at any time during the clinical trial process. For example, in late 2011 we ceased clinical development of a drug candidate, CTS-1027, for which we had incurred approximately $31.3 million in research and development expenses prior to such time. The results of preclinical studies and early clinical trials of emricasan may not be predictive of the results of later-stage clinical trials. Drug candidates in later stages of clinical trials may fail to show the desired safety and efficacy traits despite having progressed through preclinical studies and initial clinical trials. A number of companies in the biopharmaceutical industry have suffered significant setbacks in advanced clinical trials due to lack of efficacy or safety profiles, notwithstanding promising results in earlier trials.

Emricasan has been the subject of six Phase 1 and four Phase 2 clinical trials. Although we believe emricasan has demonstrated evidence of a beneficial effect in patients with chronic liver disease independent of the cause of disease, we are now seeking to evaluate emricasan in targeted indications within liver disease, including certain indications for which the safety and efficacy of emricasan have not been previously evaluated. Specifically, we recently initiated a Phase 2b ACLF trial and we expect to initiate a Phase 2b CLF trial in the second half of 2014. We previously planned to initiate the Phase 2b/3 HCV-POLT trial in the second half of 2013, prior to our decision to delay such trial pending our analysis of the impact of HCV antiviral drugs on our ability to carry out the originally proposed two-year dosing study, though we still believe that this well-characterized patient population can be an important development opportunity for emricasan at some time in the future. The development program for emricasan to date has focused primarily on the treatment of HCV patients and the evaluation of the drug candidate in liver disease generally. We cannot be certain that any of our planned clinical trials will be successful, and failure in one indication may have negative consequences for the development of emricasan for other indications. For example, any safety concerns observed in our ACLF trials could limit the prospects for regulatory approval for another indication such as HCV-POLT or CLF. Any such failure may harm our business, prospects and financial condition.

The FDA regulatory approval process is lengthy and time-consuming, and if we experience significant delays in the clinical development and regulatory approval of emricasan, our business will be substantially harmed.

We may experience delays in commencing and completing clinical trials of emricasan. For example, based on recent data regarding a new HCV antiviral being developed by Gilead Sciences, we have chosen to delay our HCV-POLT Phase 2b/3 clinical trial. We may also experience delays in commencing and completing other clinical trials of emricasan. We do not know whether planned clinical trials will begin on time, need to be redesigned, enroll patients on time or be completed on schedule, if at all. Although we have recently initiated a Phase 2b ACLF trial and are targeting the initiation of a Phase 2b CLF trial in second half of 2014, any of our planned trials may be delayed for a variety of reasons, including delays related to:

 

•

the availability of financial resources for us to commence and complete our planned trials;

 

•

reaching agreement on acceptable terms with prospective contract research organizations, or CROs, and clinical trial sites, the terms of which can be subject to extensive negotiation and may vary significantly among different CROs and trial sites;

 

•

obtaining IRB approval at each clinical trial site;

 

•

recruiting suitable patients to participate in a trial;

 

•

having patients complete a trial or return for post-treatment follow-up;

 

•

clinical trial sites deviating from trial protocol or dropping out of a trial;

 

•

adding new clinical trial sites; or

 

•

manufacturing sufficient quantities of our drug candidate for use in clinical trials.

 

23

---

Table of Contents

Patient enrollment, a significant factor in the timing of clinical trials, is affected by many factors including the size and nature of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, the design of the clinical trial, competing clinical trials and clinicians’ and patients’ perceptions as to the potential advantages of the drug candidate being studied in relation to other available therapies, including any new drugs that may be approved for the indications we are investigating. In addition, significant numbers of patients who enroll in our clinical trials may drop out during the trials as a result of being offered a liver transplant in the case of ACLF and CLF patients or curative therapy for HCV infection in the case of HCV-POLT patients, or otherwise. For example, recent data regarding a new HCV antiviral being developed by Gilead Sciences suggesting the potential availability of a curative therapy for HCV infection in HCV-POLT patients has caused us to delay our Phase 2b/3 HCV-POLT trial pending further analysis of the impact of such data on our ability to recruit and maintain patient compliance during the proposed two years of dosing with emricasan, though we still believe that this well-characterized patient population can be an important development opportunity for emricasan at some time in the future. We believe we have appropriately accounted for such increased risk of dropout rates in our trials when determining expected clinical trial timelines in our planned Phase 2b ACLF and Phase 2b CLFs trials, but we cannot assure you that our assumptions are correct, or that we will not experience higher numbers of dropouts than anticipated, which would result in the delay of completion of such trials beyond our expected timelines.

We could encounter delays if physicians encounter unresolved ethical issues associated with enrolling patients in clinical trials of emricasan in lieu of prescribing existing treatments that have established safety and efficacy profiles. Further, a clinical trial may be suspended or terminated by us, the IRBs in the institutions in which such trials are being conducted, the Data Monitoring Committee for such trial, or by the FDA or other regulatory authorities due to a number of factors, including failure to conduct the clinical trial in accordance with regulatory requirements or our clinical protocols, inspection of the clinical trial operations or trial site by the FDA or other regulatory authorities resulting in the imposition of a clinical hold, unforeseen safety issues or adverse side effects, failure to demonstrate a benefit from using a drug candidate, changes in governmental regulations or administrative actions or lack of adequate funding to continue the clinical trial. If we experience termination of, or delays in the completion of, any clinical trial of emricasan, the commercial prospects for emricasan will be harmed, and our ability to generate product revenues will be delayed. In addition, any delays in completing our clinical trials will increase our costs, slow down our product development and approval process and jeopardize our ability to commence product sales and generate revenues. Any of these occurrences may harm our business, prospects, financial condition and results of operations significantly. Furthermore, many of the factors that cause, or lead to, a delay in the commencement or completion of clinical trials may also ultimately lead to the denial of regulatory approval of emricasan.

We face significant competition from other biotechnology and pharmaceutical companies and our operating results will suffer if we fail to compete effectively.

The biopharmaceutical industry is characterized by intense competition and rapid innovation. Although we believe that we hold a leading position in our understanding of caspase inhibition related to liver disease, our competitors may be able to develop other compounds or drugs that are able to achieve similar or better results. Our potential competitors include major multinational pharmaceutical companies, established biotechnology companies, specialty pharmaceutical companies and universities and other research institutions. Many of our competitors have substantially greater financial, technical and other resources, such as larger research and development staff and experienced marketing and manufacturing organizations and well-established sales forces. Smaller or early-stage companies may also prove to be significant competitors, particularly through collaborative arrangements with large, established companies. Mergers and acquisitions in the biotechnology and pharmaceutical industries may result in even more resources being concentrated in our competitors. Competition may increase further as a result of advances in the commercial applicability of technologies and greater availability of capital for investment in these industries. Our competitors may succeed in developing, acquiring or licensing on an exclusive basis drug products that are more effective or less costly than emricasan. We believe the key competitive factors that will affect the development and commercial success of our drug candidates are efficacy, safety and tolerability profile, reliability, convenience of dosing, price and reimbursement.

There are currently no therapeutic products approved for the treatment of ACLF, CLF or HCV-POLT. There are a number of marketed therapeutics used in each of these diseases to try to remove the underlying cause of the disease and prevent further liver injury. For example, if the liver damage is a result of Hepatitis B virus or HCV infection, marketed antiviral medications may be used to treat the virus that led to liver damage. If the liver damage is a result of alcoholic hepatitis, marketed alcohol addiction drugs may be used. If the liver damage is a result of obesity, diet and exercise may be prescribed along with marketed therapeutics. If the liver damage is a result of non-alcoholic steatohepatitis, or NASH, marketed drugs such as insulin sensitizers (e.g., metformin), antihyperlipidemic agents (e.g., gemfibrozil), pentoxifylline and ursodiol may be used, although none of these are approved for NASH. In addition to the marketed drugs for those indications, there are drugs in development for each of these indications. Although these marketed therapies and those in development may be efficacious, all of them take time to show an effect and as long as the underlying conditions persist there will continue to be damage to the liver. Emricasan is the only therapeutic we are aware of that is being developed specifically to reduce the level of apoptosis in the liver and as a result it may be used with these other therapies. Our estimates of disease prevalence consider the presence of these other treatments.

 

24

---

Table of Contents

In addition, the HCV landscape is expected to continue to evolve dramatically over the next five to ten years with the introduction of new interferon-free regimens, which are expected to reach the market as soon as 2014, and next generation interferon-free regimens, which may reach the market by as early as 2014, with greater efficacy and tolerability over the current antiviral therapies. Based on market research we commissioned, we estimate that treatment rates pre-transplantation would need to be 100% and cure rates would have to exceed 97% before the supply of liver transplants would outstrip the need for transplant on an annual basis.

Even if we obtain regulatory approval for emricasan, the availability and price of our competitors’ products could limit the demand, and the price we are able to charge, for emricasan. We will not achieve our business plan if the acceptance of emricasan is inhibited by price competition or the reluctance of physicians to switch from existing methods of treatment to emricasan, or if physicians switch to other new drug products or choose to reserve emricasan for use in limited circumstances. Our inability to compete with existing or subsequently introduced drug products would have a material adverse impact on our business, prospects, financial condition and results of operations.

Established pharmaceutical companies may invest heavily to accelerate discovery and development of novel compounds or to in-license novel compounds that could make emricasan less competitive. In addition, any new product that competes with an approved product must demonstrate compelling advantages in efficacy, convenience, tolerability and safety in order to overcome price competition and to be commercially successful. Accordingly, our competitors may succeed in obtaining patent protection, receiving FDA approval or discovering, developing and commercializing medicines before we do, which would have a material adverse impact on our business.

Risks Related to Our Financial Position and Capital Requirements

On September 25, 2013, we prepaid the outstanding advances under our credit facility with Oxford Finance LLC and Silicon Valley Bank, and the credit facility was terminated. Accordingly, the risk factor entitled “The terms of our credit facility place restrictions on our operating and financial flexibility” has been deleted.

 

ITEM 2.

UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS

Unregistered Sales of Equity Securities

From July 1, 2013 through September 30, 2013, we issued and sold the equity securities described below.

In July 2013, as consideration for entering into our credit facility we issued to lenders warrants to purchase up to an aggregate of 111,112 shares of our Series B convertible preferred stock, at an initial exercise price of $0.90 per share. In connection with the completion of our initial public offering in July 2013, the warrants became exercisable for an aggregate of 13,468 shares of common stock, at an exercise price of $7.43 per share.

The securities described in this Item 2 were issued to investors in reliance upon the exemption from the registration requirements of the Securities Act, as set forth in Section 4(2) under the Securities Act and Regulation D promulgated thereunder relative to transactions by an issuer not involving any public offering, to the extent an exemption from such registration was required. All purchasers of the equity securities described above represented to us in connection with their purchase that they were accredited investors and were acquiring the securities for their own account for investment purposes only and not with a view to, or for sale in connection with, any distribution thereof and that they could bear the risks of the investment and could hold the securities for an indefinite period of time. The purchasers received written disclosures that the securities had not been registered under the Securities Act and that any resale must be made pursuant to a registration statement or an available exemption from such registration.

All of the foregoing securities are deemed restricted securities for purposes of the Securities Act. All securities described in this Item 2 included appropriate legends setting forth that the securities had not been registered and the applicable restrictions on transfer. No underwriters were involved in the transactions described in this Item 2.

Use of Proceeds

On July 24, 2013, our registration statement on Form S-1 (File No. 333-189305), which registered an aggregate amount of up to $69.0 million of our common stock, was declared effective by the SEC for our initial public offering. On July 25, 2013, we filed a Registration Statement pursuant to Rule 462(b) (File No. 333-190115), which registered an additional aggregate amount of up to $6.9 million of our common stock. At the closing of the offering on July 30, 2013, we sold 6,000,000 shares of common stock at an initial public offering price of $11.00 per share and received gross proceeds of $66.0 million, which resulted in net proceeds to us of approximately $59.0 million, after underwriting discounts and commissions of approximately $4.6 million and offering-related transaction costs of approximately $2.4 million. None of the expenses associated with the initial public offering were paid to directors, officers, persons owning ten percent or more of any class of equity securities, or to their associates, or to our affiliates. Stifel, Nicolaus & Company, Incorporated and Piper Jaffray & Co. acted as joint book-running managers and JMP Securities LLC and SunTrust Robinson Humphrey, Inc. acted as co-managers for the offering. On August 23, 2013, the underwriters’ 30-day over-allotment option to purchase an additional 900,000 shares of common stock in the offering expired without being exercised and the offering terminated.

 

25

---

Table of Contents

We intend to use the net offering proceeds to fund the clinical development of emricasan and for working capital and general corporate purposes. Pending use of the net proceeds, we plan to invest the net proceeds from this offering in short- and intermediate-term, interest-bearing obligations, investment-grade instruments, certificates of deposit or direct or guaranteed obligations of the U.S. government. Through September 30, 2013, the net proceeds have been applied as follows: $1.0 million towards the clinical development of emricasan and $1.4 million towards working capital and general corporate purposes.

 

ITEM 3.

DEFAULTS UPON SENIOR SECURITIES

None.

 

ITEM 4.

MINE SAFETY DISCLOSURES

None.

 

ITEM 5.

OTHER INFORMATION

None.

 

ITEM 6.

EXHIBITS

A list of exhibits is set forth on the Exhibit Index immediately following the signature page of this quarterly report on Form 10-Q, and is incorporated herein by reference.

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.

 

						CONATUS PHARMACEUTICALS INC.
Date: November 14, 2013						/s/ Steven J. Mento, Ph.D.
						Steven J. Mento, Ph.D. President and Chief Executive Officer (principal executive officer)
Date: November 14, 2013						/s/ Charles J. Cashion
						Charles J. Cashion Senior Vice President, Finance, Chief Financial Officer and Secretary (principal financial and accounting officer)

 

26

---

Table of Contents

INDEX TO EXHIBITS

 

Exhibit Number		Description
3.1(1)		Amended and Restated Certificate of Incorporation
3.2(1)		Amended and Restated Bylaws
4.1(3)		Specimen Common Stock Certificate
4.2(2)		First Amended and Restated Investor Rights Agreement, dated February 9, 2011
4.3(2)		Form of Warrant issued to investors in the Registrant’s 2013 bridge financing
4.4(3)		Form of Warrant issued to lenders under the Loan and Security Agreement, dated as of July 3, 2013, by and among the Registrant, Oxford Finance LLC, Silicon Valley Bank and the other lenders party thereto
10.1(4)		Form of Indemnity Agreement for Directors and Officers
10.2#(3)		2013 Incentive Award Plan and form of option agreement thereunder
10.3#(3)		2013 Employee Stock Purchase Plan
10.4#(3)		Non-Employee Director Compensation Program
10.5#(3)		Employee Incentive Compensation Plan
10.6#(3)		Annual Incentive Plan
10.7#(3)		Amendment to Employment Agreement, dated July 2, 2013, by and between Steven J. Mento, Ph.D. and the Registrant
10.8#(3)		Amendment to Employment Agreement, dated July 2, 2013, by and between Alfred P. Spada, Ph.D. and the Registrant
10.9#(3)		Amendment to Employment Agreement, dated July 2, 2013, by and between Gary C. Burgess, M.B., Ch.B. M.Med and the Registrant
10.10(3)		Amendment to Promissory Note, dated July 3, 2013, by and between the Registrant and Pfizer Inc.
10.11(3)		Loan and Security Agreement, dated as of July 3, 2013, by and among the Registrant, Oxford Finance LLC, Silicon Valley Bank and the other lenders party thereto
31.1		Certification of Chief Executive Officer pursuant to Rules 13a-14 and 15d-14 promulgated pursuant to the Securities Exchange Act of 1934, as amended
31.2		Certification of Chief Financial Officer pursuant to Rules 13a-14 and 15d-14 promulgated pursuant to the Securities Exchange Act of 1934, as amended
32.1*		Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2*		Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS**		XBRL Instance Document
101.SCH**		XBRL Taxonomy Extension Schema Document
101.CAL**		XBRL Taxonomy Extension Calculation Linkbase Document
101.DEF**		XBRL Taxonomy Extension Definition Linkbase Document
101.LAB**		XBRL Taxonomy Extension Label Linkbase Document
101.PRE**		XBRL Taxonomy Extension Presentation Linkbase Document

 

27

---

Table of Contents

(1)	Incorporated by reference to the Registrant’s Current Report on Form 8-K, filed with the SEC on August 1, 2013.

(2)	Incorporated by reference to the Registrant’s Registration Statement on Form S-1 (Registration No. 333- 189305), filed with the SEC on June 14, 2013.

(3)	Incorporated by reference to Amendment No. 2 to the Registrant’s Registration Statement on Form S-1 (Registration No. 333- 189305), filed with the SEC on July 8, 2013.

(4)	Incorporated by reference to Amendment No. 1 to the Registrant’s Registration Statement on Form S-1 (Registration No. 333- 189305), filed with the SEC on July 1, 2013.

#	Indicates management contract or compensatory plan.

*

These certifications are being furnished solely to accompany this quarterly report pursuant to 18 U.S.C. Section 1350, and are not being filed for purposes of Section 18 of the Securities Exchange Act of 1934 and are not to be incorporated by reference into any filing of the Registrant, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

**

Users of this data are advised that pursuant to Rule 406T of Regulation S-T, this XBRL information is being furnished and not filed herewith for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and Sections 11 or 12 of the Securities Act of 1933, as amended, and is not to be incorporated by reference into any filing, or part of any registration statement or prospectus, of the Registrant, whether made before or after the date hereof, regardless of any general incorporation language in such filing.

 

28