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Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 


 

FORM 10-Q

 

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

 

For the quarterly period ended September 30, 2014

 

or

 

o        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: 001-34973

 

Anacor Pharmaceuticals, Inc.

(Exact Name of Registrant as Specified in Its Charter)

 

Delaware

 

25-1854385

(State or Other Jurisdiction of

 

(I.R.S. Employer

Incorporation or Organization)

 

Identification No.)

 

1020 East Meadow Circle

Palo Alto, California 94303-4230

(Address of Principal Executive Offices) (Zip Code)

 

(650) 543-7500

(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 o

 

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 during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes x  No o

 

Indicate by check mark whether the 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” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

Large accelerated filer o

 

Accelerated filer x

 

 

 

Non-accelerated filer o

 

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

 

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

 

As of October 30, 2014, there were 42,897,186 shares of the registrant’s common stock outstanding.

 

 

 



Table of Contents

 

Table of Contents

 

Anacor Pharmaceuticals, Inc.

Form 10-Q

Index

 

 

 

Page

 

 

 

 

PART I. FINANCIAL INFORMATION

 

 

 

 

Item 1.

Financial Statements (Unaudited)

3

 

Condensed Consolidated Balance Sheets as of September 30, 2014 and December 31, 2013

3

 

Condensed Consolidated Statements of Operations for the Three and Nine Months Ended September 30, 2014 and 2013

4

 

Condensed Consolidated Statements of Comprehensive Loss for the Three and Nine Months Ended September 30, 2014 and 2013

5

 

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2014 and 2013

6

 

Notes to Condensed Consolidated Financial Statements

7

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

28

Item 3.

Quantitative and Qualitative Disclosures About Market Risk

40

Item 4.

Controls and Procedures

40

 

 

 

 

PART II. OTHER INFORMATION

 

Item 1.

Legal Proceedings

41

Item 1A.

Risk Factors

41

Item 6.

Exhibits

73

Signatures

 

74

 

2



Table of Contents

 

PART I. FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

Anacor Pharmaceuticals, Inc.

Condensed Consolidated Balance Sheets

(In Thousands)

 

 

 

September 30,

 

December 31,

 

 

 

2014

 

2013 (1)

 

 

 

(unaudited)

 

 

 

Assets

 

 

 

 

 

Current assets:

 

 

 

 

 

Cash and cash equivalents

 

$

16,858

 

$

114,755

 

Short-term investments

 

124,021

 

35,574

 

Restricted investments, short-term

 

1,071

 

1,475

 

Contract receivables

 

2,012

 

1,324

 

Inventory

 

1,366

 

 

Prepaid expenses and other current assets

 

4,234

 

2,286

 

Total current assets

 

149,562

 

155,414

 

Long-term investments

 

4,624

 

11,856

 

Restricted investments, long-term

 

2,362

 

3,155

 

Property and equipment, net

 

1,712

 

1,458

 

Other assets

 

373

 

282

 

Total assets

 

$

158,633

 

$

172,165

 

 

 

 

 

 

 

Liabilities, redeemable common stock and stockholders’ equity

 

 

 

 

 

Current liabilities:

 

 

 

 

 

Accounts payable

 

$

4,091

 

$

4,708

 

Accrued liabilities

 

15, 831

 

8,431

 

Income taxes payable

 

 

1,706

 

Deferred revenue

 

4,071

 

1,115

 

Deferred rent

 

306

 

269

 

Total current liabilities

 

24,299

 

16,229

 

Notes payable

 

28,646

 

28,018

 

Deferred revenue, less current portion

 

36,304

 

315

 

Deferred rent, less current portion

 

983

 

1,219

 

 

 

 

 

 

 

Commitments and contingencies

 

 

 

 

 

 

 

 

 

 

 

Redeemable common stock

 

4,952

 

4,952

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

Preferred stock

 

 

 

Common stock

 

42

 

41

 

Additional paid-in capital

 

270,846

 

251,839

 

Accumulated other comprehensive income (loss)

 

29

 

(2

)

Accumulated deficit

 

(207,468

)

(130,446

)

Total stockholders’ equity

 

63,449

 

121,432

 

Total liabilities, redeemable common stock and stockholders’ equity

 

$

158,633

 

$

172,165

 

 


(1) Derived from the audited financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

 

See accompanying notes.

 

3



Table of Contents

 

Anacor Pharmaceuticals, Inc.

Condensed Consolidated Statements of Operations

(In Thousands, Except Share and Per Share Data)

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Revenues:

 

 

 

 

 

 

 

 

 

Research contracts

 

$

2,889

 

$

3,611

 

$

9,978

 

$

8,743

 

Distribution and commercialization agreement

 

1,066

 

 

1,066

 

 

Total revenues

 

3,955

 

3,611

 

11,044

 

8,743

 

 

 

 

 

 

 

 

 

 

 

Operating expenses:

 

 

 

 

 

 

 

 

 

Cost of goods sold

 

202

 

 

202

 

 

Research and development

 

19,521

 

12,460

 

54,717

 

33,765

 

Selling, general and administrative

 

7,707

 

6,809

 

23,130

 

16,611

 

Trademark agreement

 

6,800

 

 

6,800

 

 

Total operating expenses

 

34,230

 

19,269

 

84,849

 

50,376

 

 

 

 

 

 

 

 

 

 

 

Loss from operations

 

(30,275

)

(15,658

)

(73,805

)

(41,633

)

Interest income

 

66

 

15

 

189

 

43

 

Interest expense

 

(1,089

)

(1,135

)

(3,278

)

(2,949

)

Loss on early extinguishment of debt

 

 

 

 

(1,381

)

Other expense

 

(44

)

(31

)

(128

)

(63

)

Net loss

 

$

(31,342

)

$

(16,809

)

$

(77,022

)

$

(45,983

)

Net loss per share — basic and diluted

 

$

(0.74

)

$

(0.41

)

$

(1.83

)

$

(1.19

)

Weighted-average number of shares used in calculating net loss per share — basic and diluted

 

42,318,906

 

40,586,376

 

41,995,292

 

38,586,027

 

 

See accompanying notes.

 

4



Table of Contents

 

Anacor Pharmaceuticals, Inc.

Condensed Consolidated Statements of Comprehensive Loss

(In Thousands)

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

Net loss

 

$

(31,342

)

$

(16,809

)

$

(77,022

)

$

(45,983

)

Change in unrealized (loss) gain on investments

 

(12

)

13

 

31

 

4

 

Comprehensive loss

 

$

(31,354

)

$

(16,796

)

$

(76,991

)

$

(45,979

)

 

See accompanying notes.

 

5



Table of Contents

 

Anacor Pharmaceuticals, Inc.

Condensed Consolidated Statements of Cash Flows

(In Thousands)

 

 

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

 

 

(unaudited)

 

Operating activities

 

 

 

 

 

Net loss

 

$

(77,022

)

$

(45,983

)

Adjustments to reconcile net loss to net cash used in operating activities:

 

 

 

 

 

Depreciation and amortization

 

357

 

400

 

Amortization of debt discount and debt issuance costs

 

755

 

576

 

Stock-based compensation

 

11,669

 

3,303

 

Amortization of premium on investments

 

840

 

286

 

Accrual of final payment on notes payable

 

 

318

 

Noncash loss on early extinguishment of debt

 

 

1,175

 

Changes in assets and liabilities:

 

 

 

 

 

Contract receivables

 

(688

)

(558

)

Inventory

 

(1,366

)

 

Prepaid and other current assets

 

(2,117

)

776

 

Other assets

 

 

(331

)

Deferred financing costs

 

 

(129

)

Accounts payable

 

(617

)

2,090

 

Accrued liabilities

 

7,400

 

1,116

 

Income taxes payable

 

(1,706

)

 

Deferred revenue

 

38,945

 

35

 

Deferred rent

 

(199

)

394

 

Net cash used in operating activities

 

(23,749

)

(36,532

)

 

 

 

 

 

 

Investing activities

 

 

 

 

 

Transfers from (to) restricted investments, net

 

1,197

 

(4,456

)

Purchases of investments

 

(160,724

)

(39,025

)

Maturities of investments

 

78,700

 

45,315

 

Acquisition of property and equipment

 

(611

)

(101

)

Net cash (used in) provided by investing activities

 

(81,438

)

1,733

 

 

 

 

 

 

 

Financing activities

 

 

 

 

 

Proceeds from the sale of redeemable common stock, net of issuance costs

 

 

4,952

 

Proceeds from the sale of common stock, net of issuance costs

 

 

22,607

 

Proceeds from issuance of notes payable

 

 

30,000

 

Principal payments on notes payable

 

 

(25,716

)

Final payment on notes payable

 

 

(1,650

)

Payment of financing fee, debt issuance costs and loan fees

 

(50

)

(877

)

Proceeds from employee stock plan purchases and the exercise of stock options by employees and nonemployee advisors

 

7,340

 

1,223

 

Net cash provided by financing activities

 

7,290

 

30,539

 

 

 

 

 

 

 

Net decrease in cash and cash equivalents

 

(97,897

)

(4,260

)

Cash and cash equivalents at beginning of period

 

114,755

 

10,335

 

Cash and cash equivalents at end of period

 

$

16,858

 

$

6,075

 

 

 

 

 

 

 

Supplemental disclosure of cash flow information

 

 

 

 

 

Cash paid for interest, including final payment on notes payable

 

$

2,660

 

$

3,853

 

Supplemental disclosure of noncash financing activities

 

 

 

 

 

Fair value of warrants to purchase common stock issued in connection with notes payable

 

$

 

$

1,815

 

 

See accompanying notes.

 

6



Table of Contents

 

Anacor Pharmaceuticals, Inc.

Notes to Condensed Consolidated Financial Statements

(unaudited)

 

1. The Company

 

Nature of Operation

 

Anacor Pharmaceuticals, Inc. (the Company) is a biopharmaceutical company focused on discovering, developing and commercializing novel small-molecule therapeutics derived from its boron chemistry platform. The Company’s first approved drug, KERYDINTM (tavaborole) topical solution, 5% (formerly known as AN2690), is an oxaborole antifungal approved by the U.S. Food and Drug Administration (FDA) in July 2014 for the topical treatment of onychomycosis of the toenails. In July 2014, the Company entered into an exclusive Distribution and Commercialization Agreement (the Sandoz Agreement) with Sandoz Inc. (together with its affiliates, Sandoz), a Novartis company, pursuant to which Sandoz distributes and commercializes KERYDIN in the United States.  In September 2014, KERYDIN was launched in the United States by Sandoz pursuant to the Sandoz Agreement.  The Company’s lead product candidate is AN2728, an investigational non-steroidal topical PDE-4 inhibitor in development for the potential treatment of mild-to-moderate atopic dermatitis and psoriasis. The Company initiated Phase 3 studies of AN2728 for the treatment of mild-to-moderate atopic dermatitis in the first quarter of 2014. Beyond KERYDIN and AN2728, the Company has discovered three investigational compounds that it has out-licensed for further development. The first compound is licensed to Eli Lilly and Company (Lilly) for the potential treatment of an animal health indication.  The second compound, AN5568, also referred to as SCYX-7158, is licensed to Drugs for Neglected Diseases initiative (DNDi) for the potential treatment of human African trypanosomiasis (HAT, or sleeping sickness) and the third compound is licensed to GlaxoSmithKline LLC (GSK) for development in tuberculosis (TB). The Company also has a pipeline of other internally discovered topical and systemic boron-based compounds in early stages of research and development. These include three wholly-owned investigational product candidates. AN2718 is an investigational topical antifungal, AN2898 is an investigational non-steroidal topical PDE-4 inhibitor and AN3365 is an investigational Gram-negative antibiotic.

 

As of September 30, 2014, the Company had an accumulated deficit of $207.5 million. The Company may require additional capital to fund research and development activities, including clinical trials for its development programs and preclinical activities for its product candidates. Management believes that the Company’s existing capital resources, including the net proceeds remaining from the Company’s October 2014 issuance of Convertible Notes (as defined below) after repayment of the Loan Agreement (as defined below) (see Note 12), together with the payments it is expected to receive based on sales of KERYDIN under the Sandoz Agreement, will be sufficient to meet its anticipated operating requirements for at least the next twelve months. In the future, the Company may elect to finance its cash needs through public or private equity offerings, debt financings or licensing, collaboration or other similar arrangements, or a combination of these sources.

 

2. Summary of Significant Accounting Policies

 

Interim Financial Information

 

The accompanying condensed consolidated financial statements as of September 30, 2014 and for the three and nine months ended September 30, 2014 and 2013 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, which include only normal recurring adjustments, necessary to state fairly the results included in the condensed consolidated financial statements for the interim periods presented. The December 31, 2013 balance sheet is derived from the audited financial statements for the year ended December 31, 2013 but does not include all the disclosures necessary for audited financial statements. The financial data and other information disclosed in these notes to the condensed consolidated financial statements related to the three and nine month periods are unaudited. The results for the three and nine months ended September 30, 2014 are not necessarily indicative of results to be expected for the year ending December 31, 2014 or for any other interim period or for any future year.

 

7



Table of Contents

 

These condensed consolidated financial statements follow the requirements of the Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by U.S. generally accepted accounting principles (GAAP) for annual periods can be condensed or omitted. For more complete financial information, these condensed consolidated financial statements, and the notes hereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2013 included in the Company’s Annual Report on Form 10-K filed with the SEC on March 17, 2014.

 

The Company’s significant accounting policies are more fully described in Note 2 of the notes to the financial statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013.

 

Principles of Consolidation

 

The condensed consolidated financial statements include the accounts of the Company and its wholly-owned subsidiary, Anacor IP Holdings, Ltd., which was incorporated in the Cayman Islands on October 1, 2013. All intercompany balances and transactions have been eliminated in consolidation.

 

Use of Estimates

 

The preparation of the condensed consolidated financial statements in accordance with U.S. GAAP requires the Company to make estimates and judgments in certain circumstances that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. In preparing these condensed consolidated financial statements, management has made its best estimates and judgments of certain amounts included in the condensed consolidated financial statements, giving due consideration to materiality. On an ongoing basis, the Company evaluates its estimates, including those related to revenue recognition, fair values of financial instruments in which it invests, inventory, income taxes, preclinical study and clinical trial accruals, accrued compensation, stock compensation and other contingencies. Management bases its estimates on historical experience or on various other assumptions that it believes to be reasonable under the circumstances. Actual results could differ from these estimates.

 

Cash and Cash Equivalents, Short-Term Investments, Long-Term Investments and Restricted Investments

 

The Company considers all highly liquid investments with a maturity of three months or less at the time of purchase to be cash and cash equivalents. Unless restricted, investments with a maturity date of more than three months, but less than twelve months, from the date of purchase are considered short-term investments and are classified as current assets. Long-term investments have contractual maturities at the date of purchase of over one but less than two years and are classified as noncurrent assets until such time as the time to maturity becomes one year or less, at which time they are reclassified to short-term investments. The Company’s investments in marketable securities are classified as available for sale (see Note 3). Securities available for sale are carried at estimated fair value, with unrealized gains and losses reported as part of accumulated other comprehensive income or loss, a separate component of stockholders’ equity. The Company has estimated the fair value amounts by using available market information. The cost of available for sale securities sold is based on the specific-identification method. Restricted investments are classified as a current or noncurrent asset based upon the terms of the relevant contract and, in some cases, management’s estimate of when the restrictions will be eliminated.

 

Under its facility lease agreements, the Company is required to deliver letters of credit securing the performance of its obligations thereunder. At both September 30, 2014 and December 31, 2013, these letters of credit were secured by approximately $0.2 million of long-term restricted investments.

 

Fair Value of Financial Instruments

 

The carrying amounts of certain of the Company’s financial instruments, including cash and cash equivalents, short-term investments, restricted investments, contract receivables and accounts payable, approximate their fair value due to their short maturities.  Based on the borrowing rates available to the Company for loans with similar terms and average maturities, the carrying value of the Company’s long-term notes payable under its Loan Agreement approximate their fair values at September 30, 2014 and December 31, 2013.

 

8



Table of Contents

 

Fair value is considered to be the price at which an asset could be exchanged or a liability transferred (an exit price) in an orderly transaction between knowledgeable, willing parties in the principal or most advantageous market for the asset or liability. Where available, fair value is based on or derived from observable market prices or other observable inputs. Where observable prices or inputs are not available, valuation models are applied. These valuation techniques involve management estimation and judgment, the degree of which is dependent on the price transparency for the instruments or market and the instruments’ complexity.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject the Company to a concentration of credit risk consist of cash and cash equivalents, short-term investments, long-term investments and restricted investments. Substantially all the Company’s cash and cash equivalents, short-term investments, long-term investments and restricted investments are held by two financial institutions that management believes are of high credit quality. Such deposits may, at times, exceed federally insured limits. At both September 30, 2014 and December 31, 2013, approximately 93% of the cash and cash equivalents were held in a money market fund invested in U.S. Treasuries, securities guaranteed as to principal and interest by the U.S. government and repurchase agreements in respect of such securities. At September 30, 2014 and December 31, 2013, approximately 57% and 100%, respectively, of the Company’s short-term investments, long-term investments and restricted investments were held in securities guaranteed as to principal and interest by the U.S. government. The Company has not experienced any losses on its deposits of cash and cash equivalents, short-term investments, long-term investments and restricted investments and management believes that its guidelines for investment of its excess cash maintain safety and liquidity through diversification and investment maturity.

 

Customer Concentration

 

For the three and nine month periods ended September 30, 2014, the Company’s revenues consisted primarily of research contract revenues from a research agreement with The Bill and Melinda Gates Foundation (Gates Foundation), distribution and commercialization agreement revenues from Sandoz (including revenues from product sales of KERYDIN to Sandoz) (see Note 8), research contract revenues from a contract with the United States Department of Defense, Defense Threat Reduction Agency (DTRA) and, for the nine month period ended September 30, 2014, research contract revenues from a collaboration agreement with Lilly. For the three and nine month periods ended September 30, 2013, the Company also recognized research contract revenues from its collaboration with GSK, which, during the nine month period ended September 30, 2013, accounted for 10% or more of its total revenues. Research collaborators, including the Gates Foundation, GSK and Lilly, have accounted for significant revenues in the past and may not provide research contract revenues in the future under existing agreements and/or new collaboration agreements, which may have a material effect on the Company’s operating results.

 

The following table shows the percentage of revenues attributable to contracts with customers that accounted for 10% or more of total revenues in the specified periods:

 

 

 

Three Months
Ended September 30,

 

Nine Months
Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Gates Foundation

 

45

%

47

%

46

%

34

%

Sandoz

 

27

%

 

10

%

 

DTRA

 

15

%

 

22

%

 

Lilly

 

 

28

%

12

%

35

%

GSK

 

*

 

*

 

*

 

12

%

 


*            less than 10% of total revenue

 

9



Table of Contents

 

Contract Receivables

 

At September 30, 2014 and December 31, 2013, the Company’s contract receivables included $0.3 million and $0.5 million, respectively, due from DTRA (see Note 8), $0.1 million and $0.7 million, respectively, due from GSK (see Note 8) and $0.4 million and $0.1 million, respectively, due from other contracts. In addition, the Company’s contract receivables at September 30, 2014 included $0.8 million due under a research collaboration agreement with the Global Alliance for Livestock Veterinary Medicine (GALVmed) (see Note 8) and $0.4 million due for product sales of KERYDIN to Sandoz.

 

The Company’s contract receivables are primarily composed of amounts due under collaboration, research and distribution and commercialization agreements and government contracts and the Company believes that the credit risks associated with the parties to these agreements are not significant. During the three and nine months ended September 30, 2014, the Company has not written-off any contract receivables and, accordingly, does not have an allowance for doubtful accounts as of September 30, 2014.

 

Inventory

 

Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method for all inventories, which are valued based on costs calculated for each production batch. The Company periodically evaluates the carrying value of inventory on hand for potential excess quantities and obsolescence. As a result of such evaluations, no charges were recorded in the three or nine months ended September 30, 2014.

 

Revenue Recognition

 

For the three and nine month periods ended September 30, 2014, the Company’s research contract revenues were generated primarily through research and development collaboration agreements, which, in addition to providing funding for research and development efforts, may include non-refundable, non-creditable upfront fees, payments for achievement of specified development, regulatory and sales goals and royalties on product sales of licensed products. During these periods, the Company also generated distribution and commercialization agreement revenues from upfront payments and product sales from Sandoz.

 

The Company recognizes revenue when persuasive evidence of an arrangement exists; transfer of technology has been completed, services are performed or products have been delivered; the fee is fixed or determinable; and collection is reasonably assured.

 

For arrangements with multiple deliverables, the Company evaluates each deliverable to determine whether it qualifies as a separate unit of accounting. This determination is generally based on whether the deliverable has stand-alone value to the customer. The selling price used for each unit of accounting will be based on vendor-specific objective evidence, if available, third party evidence if vendor-specific objective evidence is not available or estimated selling price if neither vendor-specific nor third party evidence is available. Management may be required to exercise considerable judgment in determining whether a deliverable is a separate unit of accounting and in estimating the selling prices of identified units of accounting for new agreements. Where multiple deliverables are combined as a single unit of accounting, revenues are recognized based on the performance requirements of the related agreement.

 

Upfront payments for licensing the Company’s intellectual property are evaluated to determine if the licensee can obtain stand-alone value from the license separate from the value of the research and development services to be provided by the Company. Typically, the Company has determined that the licenses it has granted to research and development collaborators do not have stand-alone value separate from the value of the research and development services provided. As such, upfront payments are recorded as deferred revenue in the condensed consolidated balance sheets and are recognized as research contract revenue ratably over the contractual or estimated performance period that is consistent with the term of the research and development obligations contained in the research and development collaboration agreement. When stand-alone value is identified, the related consideration is recorded as revenue in the period in which the license or other intellectual property rights are issued.

 

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Some arrangements involving the licensing of the Company’s intellectual property, the provision of research and development services or both may also include exclusivity clauses whereby the Company agrees that, for a specified period of time, it will not conduct further research on licensed compounds or on compounds that would compete with licensed compounds or that it will do so only on a limited basis. Such provisions may also restrict the future development or commercialization of such compounds. The Company does not treat such exclusivity clauses as a separate element within an arrangement and any upfront payments received related to the exclusivity clause would be allocated to the identified elements in the arrangement and recognized as described in the preceding paragraph.

 

Payments resulting from the Company’s efforts under research and development agreements or government grants are recognized as the activities are performed and are presented on a gross basis. Revenue is recorded on a gross basis because the Company acts as a principal, with discretion to choose suppliers, bears credit risk and performs part of the services. The costs associated with these activities are reflected as a component of research and development expense in the condensed consolidated statements of operations and the revenues recognized from such activities approximate these costs.

 

For certain contingent payments under research or development arrangements, the Company recognizes revenue using the milestone method. Under the milestone method, a payment that is contingent upon the achievement of a substantive milestone is recognized in its entirety in the period in which the milestone is achieved. A milestone is an event (i) that can be achieved based in whole or in part on either the Company’s performance or on the occurrence of a specific outcome resulting from the Company’s performance, (ii) for which there is substantive uncertainty at the date the arrangement is entered into that the event will be achieved and (iii) that would result in additional payments being due to the Company. The determination that a milestone is substantive requires estimation and judgment and is made at the inception of the arrangement. Milestones are considered substantive when the consideration earned from the achievement of the milestone is (i) commensurate with either the Company’s performance to achieve the milestone or the enhancement of value of the item delivered as a result of a specific outcome resulting from the Company’s performance to achieve the milestone, (ii) relates solely to past performance and (iii) is reasonable relative to all deliverables and payment terms in the arrangement. In making the determination as to whether a milestone is substantive or not, management of the Company considers all facts and circumstances relevant to the arrangement, including factors such as the scientific, regulatory, commercial and other risks that must be overcome to achieve the respective milestone, the level of effort and investment required to achieve the respective milestone and whether any portion of the milestone consideration is related to future performance or deliverables. The Company has analyzed future contingent payments under existing research or development arrangements and determined that none meet the definition of milestone payments.

 

Other contingent payments received for which payment is either contingent solely upon the passage of time or the results of a collaborative partner’s performance (bonus payments) are not accounted for using the milestone method. Such bonus payments will be recognized as revenue when earned and when collectibility is reasonably assured.

 

Royalties based on reported sales of licensed products will be recognized based on contract terms when reported sales are reliably measurable and collectibility is reasonably assured. As of September 30, 2014, the Company had not earned any royalty revenue from product sales.

 

Arrangements under which the Company grants another party distribution and commercialization rights to one of its products and that involve multiple other deliverables are evaluated based on the accounting guidance for multiple-element arrangements to determine whether any of the deliverables qualifies as a separate unit of accounting. If the Company determines that the deliverables do not have stand alone value because each one of them has value only as it relates to maintaining and supporting the other party’s distribution and commercialization rights, then all deliverables are combined as a single unit of accounting, all arrangement consideration is allocated to that combined unit of accounting and revenues are recognized based on the performance requirements of the related agreement.  Upfront payments received under such agreements are recorded as deferred revenue in the condensed consolidated balance sheets and are recognized as distribution and commercialization agreement revenue ratably over the contractual or estimated performance period that is consistent with the term of the Company’s obligations under the agreement. If any deliverable is determined to have stand-alone value to the customer, it will be treated as

 

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a separate unit of accounting and arrangement consideration will be allocated to that unit of accounting based on its selling price, which will be determined based on vendor-specific objective evidence, if available, third party evidence if vendor-specific objective evidence is not available or estimated selling price if neither vendor-specific nor third party evidence is available. For such separate units of accounting, the allocated arrangement consideration will be recognized as services are performed or products have been delivered, when the fee is fixed or becomes determinable and when collection is reasonably assured.

 

For product sales under a distribution and commercialization agreement, the Company recognizes revenue from the supply of product to the other party when all four revenue recognition criteria have been met (i.e., persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed or determinable and collection is reasonably assured) and when risk of loss and title passes to the customer.

 

Gross profit sharing or royalty payments based on reported gross profits or sales of products for which distribution and commercialization rights have been granted to another party will be recognized based on contract terms when reported gross profits or sales are reliably measurable and collectibility is reasonably assured.

 

Preclinical Study and Clinical Trial Accruals and Deferred Advance Payments

 

The Company estimates preclinical study and clinical trial expenses based on the services performed pursuant to contracts with research institutions and clinical research organizations that conduct these activities on its behalf. In recording service fees, the Company estimates the time period over which the related services will be performed and compares the level of effort expended through the end of each period to the cumulative expenses recorded and payments made for such services and, as appropriate, accrues additional service fees or defers any non-refundable advance payments until the related services are performed. If the actual timing of the performance of services or the level of effort varies from the estimate, the Company will adjust its accrual or deferred advance payment accordingly. If the Company later determines that it no longer expects the services associated with a deferred non-refundable advance payment to be rendered, the deferred advance payment will be charged to expense in the period that such determination is made.

 

Stock-Based Compensation

 

Employee stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period). Stock-based compensation expense is allocated among cost of goods sold, research and development and selling, general and administrative expenses, or included in the inventory carrying value and absorbed into inventory, based on the function of the related employee. Stock option awards granted to the Company’s nonemployee directors for their board-related services are included in employee stock-based compensation in accordance with current accounting standards. The Company uses the Black-Scholes option-pricing model to estimate the fair value of its time-based vesting stock option awards and uses the straight-line (single-option) method for expense attribution. The Company uses a Monte Carlo valuation method to estimate the fair value of its market-based vesting performance stock option and restricted stock unit awards. The Company estimates forfeitures and recognizes expense only for those shares expected to vest.

 

The Company accounts for equity instruments issued to nonemployees based on their fair values on the measurement dates using the Black-Scholes option-pricing model. The fair values of the options granted to nonemployees are remeasured as they vest. As a result, the noncash charge to operations for nonemployee options that vest in any given reporting period is affected by changes in the fair value of the Company’s common stock during that period.

 

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Net Loss per Share

 

Basic net loss per share is calculated by dividing the net loss by the weighted-average number of shares outstanding during the period, without consideration for potentially dilutive shares. Diluted net loss per share includes the effect of all potential shares, consisting of stock options (including performance stock options), restricted stock units (including performance restricted stock units) and warrants outstanding for the period, determined using the treasury-stock method. For purposes of this calculation, potentially dilutive securities consisting of stock options, restricted stock units and warrants are considered to be potential shares and, for each period presented in these financial statements, are excluded in the calculation of diluted net loss per share because their effect would be antidilutive. The following table presents the calculation of basic and diluted net loss per share (in thousands, except share and per share data):

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Net loss per share:

 

 

 

 

 

 

 

 

 

Numerator:

 

 

 

 

 

 

 

 

 

Net loss

 

$

(31,342

)

$

(16,809

)

$

(77,022

)

$

(45,983

)

Denominator:

 

 

 

 

 

 

 

 

 

Weighted-average number of shares used in calculating net loss per share—basic and diluted

 

42,318,906

 

40,586,376

 

41,995,292

 

38,586,027

 

Net loss per share—basic and diluted

 

$

(0.74

)

$

(0.41

)

$

(1.83

)

$

(1.19

)

Outstanding securities at period end not included in the computation of diluted net loss per share as they had an anti-dilutive effect:

 

 

 

 

 

 

 

 

 

Stock options and restricted stock units

 

5,535,382

 

4,924,864

 

5,535,382

 

4,924,864

 

Warrants to purchase common stock

 

40,623

 

919,857

 

40,623

 

919,857

 

 

 

5,576,005

 

5,844,721

 

5,576,005

 

5,844,721

 

 

Recent Accounting Pronouncements

 

In August 2014, the Financial Accounting Standards Board (FASB) issued an accounting standards update that set forth guidance relating to the evaluation of an entity’s ability to continue as a going concern. The guidance establishes management’s responsibility for evaluating whether there is substantial doubt about an entity’s ability to continue as a going concern in connection with preparing financial statements for each annual and interim reporting period. The guidance also requires certain disclosures about relevant conditions and events when there is substantial doubt about an entity’s ability to continue as a going concern. This guidance is effective for annual and interim reporting periods ending after December 15, 2016, with early adoption permitted. The Company will evaluate the guidance under this update and present the required disclosures on the Company’s financial statements at the time of adoption.

 

In June 2014, the FASB issued a new accounting standard on accounting for share-based payments for performance-based stock awards, which will require that a performance target that affects vesting and that could be achieved after the required service period be treated as a performance condition. The Company does not currently have any performance-based stock awards that meet these conditions. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2015. The Company is currently evaluating the effect that the updated standard will have on the Company’s consolidated financial statements.

 

In May 2014, the FASB issued a new accounting standard on revenue from contracts with customers, which will require the Company to recognize revenue when it transfers promised goods or services to a customer in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. The updated standard will replace most existing revenue recognition guidance under U.S. GAAP when it becomes effective and will permit the use of either the retrospective or cumulative effect transition method. Early adoption is not permitted. The standard also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. The Company has not yet selected a transition method and is currently evaluating the effect that the updated standard will have on the Company’s consolidated financial statements and related disclosures.

 

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In July 2013, a new accounting standard was issued that requires the netting of unrecognized tax benefits against a deferred tax asset for a net operating loss carryforward or other carryforward that would apply in the settlement of uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same-jurisdiction net operating loss or other tax carryforwards that would be utilized, rather than only against carryforwards that are created by the unrecognized tax benefits. The new standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. The Company adopted this guidance as of January 1, 2014, and its adoption did not have an effect on the Company’s financial statements.

 

3. Marketable Securities and Fair Value Measurements

 

The following tables summarize the estimated fair values of the Company’s financial assets measured on a recurring basis as of the dates indicated below. Such financial assets are comprised solely of available for sale securities with remaining contractual maturities of less than two years.

 

The input levels used in the fair value measurements, the amortized cost and fair value of marketable securities, with gross unrealized gains and losses, were as follows (in thousands and unaudited):

 

September 30, 2014

 

Input
Level

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair Value

 

Money market fund

 

Level 1

 

$

15,701

 

$

 

$

 

$

15,701

 

Federal agency securities

 

Level 2

 

75,039

 

28

 

 

75,067

 

Commercial paper

 

Level 2

 

15,527

 

22

 

 

15,549

 

Corporate debt securities

 

Level 2

 

42,418

 

1

 

(22

)

42,397

 

Total available for sale securities

 

 

 

$

148,685

 

$

51

 

$

(22

)

$

148,714

 

Classified as:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

 

 

 

 

 

 

 

$

16,858

 

Short-term investments

 

 

 

 

 

 

 

 

 

124,021

 

Restricted investments, short-term

 

 

 

 

 

 

 

 

 

1,071

 

Long-term investments

 

 

 

 

 

 

 

 

 

4,624

 

Restricted investments, long-term

 

 

 

 

 

 

 

 

 

2,140

 

Total available for sale securities

 

 

 

 

 

 

 

 

 

$

148,714

 

 

December 31, 2013

 

Input
Level

 

Amortized
Cost

 

Gross
Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair Value

 

Money market fund

 

Level 1

 

$

107,253

 

$

 

$

 

$

107,253

 

Federal agency securities

 

Level 2

 

59,341

 

2

 

(4

)

59,339

 

Total available for sale securities

 

 

 

$

166,594

 

$

2

 

$

(4

)

$

166,592

 

Classified as:

 

 

 

 

 

 

 

 

 

 

 

Cash and cash equivalents

 

 

 

 

 

 

 

 

 

$

114,755

 

Short-term investments

 

 

 

 

 

 

 

 

 

35,574

 

Restricted investments, short-term

 

 

 

 

 

 

 

 

 

1,475

 

Long-term investments

 

 

 

 

 

 

 

 

 

11,856

 

Restricted investments, long-term

 

 

 

 

 

 

 

 

 

2,932

 

Total available for sale securities

 

 

 

 

 

 

 

 

 

$

166,592

 

 

All cash equivalents, short-term investments and short-term restricted investments held at September 30, 2014 and December 31, 2013 had maturities as of these dates of less than one year. Long-term investments and long-term restricted investments had maturities as of these dates of more than one but less than two years.

 

None of the available for sale securities held as of September 30, 2014 has been in a continuous unrealized loss position for more than one year. As of September 30, 2014, unrealized losses on available for sale investments are not attributed to credit risk and are considered to be temporary. The Company believes that it is more-likely-than-not that investments in an unrealized loss position will be held until maturity or the recovery of the cost basis of the investment. To date, the Company has not recorded any impairment charges on marketable securities related to other-than-temporary declines in market value.

 

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Management does not intend to sell these securities and believes that the Company will be able to hold these securities to maturity and recover their amortized cost bases. There were no realized gains or losses recognized from the sale of marketable securities for the three and nine months ended September 30, 2014 and 2013.

 

In measuring fair value, the Company evaluates valuation techniques such as the market approach, the income approach and the cost approach. A three-level valuation hierarchy, which prioritizes the inputs to valuation techniques that are used to measure fair value, is based upon whether such inputs are observable or unobservable.

 

Observable inputs reflect market data obtained from independent sources, while unobservable inputs reflect market assumptions made by the reporting entity. The three-level hierarchy for the inputs to valuation techniques is briefly summarized as follows:

 

·                  Level 1—Observable inputs such as quoted prices (unadjusted) for identical instruments in active markets at the reporting date. Active markets are those in which transactions for the asset or liability occur in sufficient frequency and volume to provide pricing information on an ongoing basis;

 

·                  Level 2—Observable inputs such as quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active, or model-derived valuations whose significant inputs are either directly or indirectly observable; and

 

·                  Level 3—Unobservable inputs that reflect management’s assumptions and best estimates of inputs that market participants would use in pricing the asset or liability at the reporting date.

 

During the three and nine months ended September 30, 2014 and September 30, 2013, there were no transfers between Level 1 and Level 2 financial assets. At September 30, 2014 and December 31, 2013, the Company utilized the market approach to measure fair value for its marketable securities. The market approach uses prices and other relevant information generated by market transactions involving identical or comparable instruments. The fair values of the money market fund (Level 1) were based on quoted market prices in an active market. Federal agency securities, commercial paper and corporate debt securities (Level 2) are valued using third party pricing sources that apply applicable inputs and other relevant data, such as quoted prices, interest rates and yield curves, into their models to estimate fair value.

 

4. Inventory

 

In the three months ended September 30, 2014, the Company recorded inventory related to the manufacturing of its KERYDIN drug product. Inventories consist of the following (in thousands):

 

 

 

September 30, 2014

 

 

 

(unaudited)

 

 

 

 

 

Raw materials

 

$

129

 

Work in progress

 

963

 

Finished goods

 

274

 

Total inventory

 

$

1,366

 

 

The Company obtained FDA approval of KERYDIN in July 2014 and began to capitalize inventory costs on the balance sheet during that month. As of September 30, 2014, all inventories were related to KERYDIN drug product.

 

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5. Accrued Liabilities

 

Accrued liabilities consisted of the following (in thousands):

 

 

 

September 30, 2014

 

December 31, 2013

 

 

 

(unaudited)

 

 

 

 

 

 

 

 

 

Accrued compensation

 

$

3,440

 

$

3,321

 

Accrued preclinical study and clinical trial costs

 

8,568

 

2,799

 

Other

 

3,823

 

2,311

 

Total accrued liabilities

 

$

15,831

 

$

8,431

 

 

6. Commitments and Contingencies

 

Indemnification Obligations

 

The Company, as permitted under Delaware law and in accordance with its bylaws, indemnifies its officers and directors for certain events or occurrences, subject to certain limits, if the officer or director is or was serving in such capacity at the Company’s request at the time of the event or occurrence. The term of the indemnification period is equal to the officer’s or director’s lifetime.

 

The maximum amount of potential future indemnification is unlimited; however, the Company currently holds director and officer liability insurance. This insurance limits the Company’s exposure and may enable it to recover a portion of any future amounts paid. The Company believes that the fair value of these indemnification obligations is minimal. Accordingly, the Company has not recognized any liabilities relating to these obligations for any period presented.

 

The Company has certain agreements with collaboration partners, contract research organizations and other parties with which it does business that contain indemnification provisions pursuant to which the Company typically agrees to indemnify the party against certain types of third party claims. The Company accrues for known indemnification claims when a loss is probable and can be reasonably estimated. The Company would also accrue for estimated incurred but unidentified indemnification claims based on historical activity. There were no accruals for, or expenses related to, indemnification claims for any period presented.

 

Legal Proceedings

 

The Company is not a party to any material legal proceedings at this time. From time to time, the Company may be involved in litigation relating to claims arising out of its ordinary course of business.

 

7. Notes Payable (Loan Agreement)

 

On June 7, 2013, the Company entered into a loan and security agreement (the Loan Agreement) with Hercules Technology Growth Capital, Inc. as collateral agent and a lender and Hercules Technology III, L.P. as a lender (the lenders, or together Hercules), providing for loans to the Company of up to $45.0 million in three tranches of $30.0 million, $10.0 million and $5.0 million.

 

The first $30.0 million tranche was drawn at the closing of the transaction, at which time the Company repaid $22.6 million in remaining obligations associated with its then-existing loan facility. The Company elected not to draw the second tranche of $10.0 million, which was available to the Company from the closing date of the Loan Agreement until December 5, 2013. The Company also elected not to draw the third tranche of $5.0 million, which was available to the Company from the date of FDA approval of KERYDIN until August 6, 2014. The interest rate applicable to the loans outstanding under the Loan Agreement was a variable rate based upon the greater of either (i) 11.65% and (ii) the sum of (a) the Prime Rate (as defined in the Loan Agreement) as reported in The Wall Street Journal minus 5.25%, plus (b) 11.65%; with a maximum interest rate of 14.90%. As a result of the FDA’s approval of KERYDIN in July 2014, the end of the interest only period for payments under the Loan Agreement was automatically extended from January 1, 2015 to July 1, 2015. Equal monthly payments of principal and interest were scheduled to begin at that time and continue through the scheduled maturity date of July 1, 2017.

 

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Through September 30, 2014, the Company paid Hercules financing and amendment fees of $0.6 million and incurred other debt issuance costs, including legal fees, of $0.5 million in connection with the Loan Agreement. These fees were accounted for as a debt discount and deferred debt issuance costs, respectively. Any repayment of all or a portion of the loan prior to maturity, required the Company to pay Hercules a prepayment penalty fee, based on a percentage of the then outstanding principal balance, equal to 2% if the prepayment occurred prior to June 7, 2015 or 1% if the prepayment occurred after such date but prior to July 1, 2017.

 

The Loan Agreement included customary affirmative and restrictive covenants, and was amended in December 2013 to include a liquidity covenant requiring the Company to maintain certain minimum balances in its United States bank and investment accounts while at the same time increasing the amount of investments the Company was permitted to make in its foreign subsidiaries. The Loan Agreement also included standard events of default, including payment defaults, breaches of covenants following any applicable cure period, a material impairment in the perfection or priority of Hercules’ security interest in or the value of the collateral and a material impairment of the prospect of repayment of the Company’s obligations under the Loan Agreement.

 

Upon an occurrence and during the continuance of an event of default, a default interest rate of an additional 5% would have applied to the outstanding loan balances, and Hercules would have been permitted to declare all outstanding obligations immediately due and payable and take such other actions as were set forth in the Loan Agreement.

 

As of September 30, 2014, the Company’s obligations under the Loan Agreement were secured by substantially all of the assets of the Company except intellectual property. The Company’s intellectual and other property was subject to certain negative pledge and other restrictions set forth in the Loan Agreement, subject to certain exceptions.

 

In connection with the Loan Agreement, the Company issued warrants to Hercules to purchase 528,375 shares of the Company’s common stock at an exercise price of $5.11 per share (the Warrants).

 

The fair value of the warrants issued was approximately $1.8 million and was calculated using a Black-Scholes valuation model with assumptions based upon observed risk-free interest rates appropriate for the expected term of the warrants; expected volatility based on the average historical volatilities of a peer group of publicly-traded companies within the Company’s industry; expected term equal to the contractual life of the warrants; and a dividend yield of 0%. The Company recorded a debt discount of $1.8 million in connection with the issuance of the Warrants.

 

The Warrants were net exercised on a cashless basis in December 2013, resulting in the issuance of 361,995 shares of the Company’s common stock to Hercules. The par value of the shares issued was reclassified from additional paid-in capital to common stock.

 

The interest on the loans outstanding under the Loan Agreement was calculated using the interest method with the debt issuance costs paid directly to Hercules (financing, amendment and legal fees) and the fair value of the warrants issued to Hercules treated as a discount on the debt. The Company’s debt issuance costs for legal fees and other debt-related expenses are included as other assets in the condensed consolidated balance sheet. The amortization of the debt discount is recorded as a noncash interest expense and the amortization of the debt issuance costs is recorded as other expense in the condensed consolidated statements of operations.

 

In June 2013, the Company recorded a loss of approximately $1.4 million on the early extinguishment of its then-existing loan facility. This loss was recorded as a loss on early extinguishment of debt in the condensed consolidated statements of operations for the nine months ended September 30, 2013.

 

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Future payments as of September 30, 2014 were as follows (in thousands):

 

Year ending December 31,

 

(unaudited)

 

Remainder of 2014

 

$

883

 

2015

 

10,211

 

2016

 

16,888

 

2017

 

8,517

 

Total minimum payments

 

36,499

 

Less amount representing interest

 

(6,499

)

Notes payable, gross

 

30,000

 

Unamortized discount on notes payable

 

(1,354

)

 

 

28,646

 

Less current portion of notes payable, including unamortized discount

 

 

Notes payable, less current portion

 

$

28,646

 

 

The Company recorded interest expense related to all borrowings of $1.1 million and $1.1 million for the three months ended September 30, 2014 and 2013, respectively, and $3.3 million and $2.9 million for the nine months ended September  30, 2014 and 2013,  respectively. Included in interest expense for these periods was $0.2 million and $0.2 million, respectively, for the three months ended September 30, 2014 and 2013, and $0.6 million and $0.5 million, respectively, for the nine months ended September 30, 2014 and 2013, for the amortization of the financing fees and debt discounts. As of September 30, 2014, the annual effective interest rate on amounts borrowed under the Loan Agreement, including the amortization of the debt discounts, was 16.29%.

 

On October 16, 2014, the Company used approximately $30.8 million of the net proceeds from the sale of Convertible Notes (as defined below) (see Note 12) to repay in full its outstanding indebtedness under, and terminate, the Loan Agreement.  As the Convertible Notes have a maturity date of October 15, 2021, with no scheduled payments of principal prior thereto, the otherwise current portion of notes payable under the Loan Agreement at September 30, 2014 was classified as long-term as the Convertible Notes were deemed to be a refinancing of the Loan Agreement.

 

8. License, Research, Development, Distribution and Commercialization Agreements

 

Sandoz Agreement

 

In July 2014, the FDA approved the New Drug Application for KERYDINTM (tavaborole) topical solution, 5% for the topical treatment of onychomycosis of the toenails. In July 2014, the Company entered into the Sandoz Agreement with Sandoz, pursuant to which Sandoz distributes and commercializes KERYDIN in the United States on an exclusive basis.  PharmaDerm, the branded dermatology business of Sandoz, is responsible for the sales and marketing of KERYDIN. In September 2014, KERYDIN was launched in the United States by Sandoz pursuant to the Sandoz Agreement.

 

The Company received two upfront payments totaling $40.0 million pursuant to the Sandoz Agreement during the three months ended September 30, 2014. The Company also expects to receive a payment of $25.0 million in January 2015 (the Launch Payment).

 

Under the Sandoz Agreement, the Company is entitled to 50% of the gross profits (defined as net sales less cost of goods sold) accrued by Sandoz on sales of KERYDIN, except that in 2015 the Company will start receiving gross profit sharing payments after the first $50.0 million of gross profits have been accrued by Sandoz as the Company will effectively receive its 50% share of such gross profits as a result of the Launch Payment. The gross profit sharing arrangement entitles the Company to cumulative minimum gross profit sharing payments totaling $45.0 million for 2016. The Company is not entitled to cumulative minimum gross profit sharing payments in any other year under the Sandoz Agreement.

 

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Under the terms of the Sandoz Agreement, the Company holds the New Drug Application for, and is responsible for any further development of, KERYDIN. In addition, the Company is responsible for maintaining regulatory approvals, reporting safety-related information to the FDA and conducting any additional clinical trials required by the FDA with respect to KERYDIN. Sandoz is responsible for setting the price for KERYDIN and for all of its selling, marketing, distribution, general and administrative costs related to the commercialization of KERYDIN. The Sandoz Agreement also grants the Company an option to repurchase all rights in KERYDIN from Sandoz on the later of three years from the first commercial sale of KERYDIN or December 31, 2017, at a price to be determined pursuant to the Sandoz Agreement. The Sandoz Agreement will continue for an initial term of 5 years and is subject to automatic 5-year renewal terms, unless terminated for certain events specified in the Sandoz Agreement. Either party may terminate the Sandoz Agreement for uncured material breaches by the other party, bankruptcy, force majeure events that remain unabated, withdrawal of KERYDIN from the market or mass tort liability actions.  In addition, Sandoz may terminate the Sandoz Agreement for convenience upon 180 days prior written notice, subject to the payment to the Company (to the extent then unpaid) of the Launch Payment and minimum gross profit sharing amounts, and in the event the Company settles, or an injunction is entered in, a third-party infringement action that prevents the Company from supplying KERYDIN to Sandoz.  The Company also has the right to terminate the Sandoz Agreement upon the expiration of all patents covering KERYDIN.

 

The Company evaluated the Sandoz Agreement under the accounting guidance for multiple-element arrangements and identified the following deliverables: the exclusive distribution rights for KERYDIN within the United States, providing KERYDIN finished product to Sandoz, maintaining regulatory approvals and related filings, reporting safety-related information to the FDA, conducting any post-approval clinical trials required by the FDA and participating in the joint steering committee. The Company determined that these deliverables do not have stand alone value because each one of them has value only as it relates to maintaining and supporting Sandoz’s rights and ability to distribute and commercialize KERYDIN in the United States. The Company also determined that the level of effort required of the Company to meet its obligations under the Sandoz Agreement is not expected to vary significantly over the life of the Sandoz Agreement. Accordingly, the Company combined these deliverables into a single unit of accounting and allocated the entire arrangement consideration to that combined unit of accounting. The upfront payments totaling $40.0 million are being recognized on a straight line basis over the life of the last-expiring patent covering KERYDIN, a period of about 13 years. As of September 30, 2014, the Company has current and long-term deferred revenue related to the upfront payments of $3.1 million and $36.3 million, respectively. Under the Sandoz Agreement, the Company is responsible for supplying KERYDIN to Sandoz at a price equal to the Company’s manufacturing costs therefor (as calculated pursuant to the Sandoz Agreement).  The Company is currently supplying Sandoz with KERYDIN finished product manufactured by the Company’s contract manufacturers. Revenues from such product sales are being recognized at the price specified by the Sandoz Agreement when the product is picked up by Sandoz at the Company’s contract manufacturer’s facility since title passes to Sandoz and Sandoz bears the risk of loss at that time. The Company’s gross profit sharing payments under the Sandoz Agreement will be recognized when they are reliably measurable and are reported to the Company by Sandoz, typically expected to be one quarter in arrears of the related sales. The expected Launch Payment of $25.0 million will be recorded as deferred revenue when received and will be recognized in 2015, one quarter in arrears of sales, in amounts equal to 50% of the quarterly gross profits reported to the Company by Sandoz, with any remaining amount being recognized at the end of 2015. Should KERYDIN gross profits for 2015 exceed the first $50.0 million to be retained by Sandoz, the Company’s 50% share of any excess 2015 gross profits will be recognized when reliably measurable and reported to the Company by Sandoz. The $45.0 million of cumulative minimum gross profit sharing payments for 2016 will be recognized as Sandoz reports quarterly gross profits to the Company, one quarter in arrears of sales, with any remaining amount recognized at the end of 2016. Should the Company’s 50% share of KERYDIN gross profits for 2016 exceed $45.0 million, the Company’s 50% share of any excess 2016 gross profits will be recognized when reliably measurable and reported to the Company by Sandoz.

 

Revenues recognized under the Sandoz Agreement were as follows (in thousands):

 

 

 

Three Months
Ended September 30,

 

Nine Months
Ended September 30,

 

 

 

2014

 

2014

 

 

 

(unaudited)

 

Distribution and commercialization agreement revenue:

 

 

 

 

 

Amortization of upfront payments

 

$

635

 

$

635

 

Revenue from product sales

 

431

 

431

 

Total distribution and commercialization agreement revenue

 

$

1,066

 

$

1,066

 

 

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GALVmed

 

Effective in July 2014, the Company entered into a collaboration agreement with GALVmed for further development of certain drug candidates that had been developed for the treatment and prevention of African trypanosomiasis in cattle under earlier research agreements between the two parties. The GALVmed agreement provides for up to $2.5 million of research funding to be paid to the Company in installments over a research period of 19 months, expected to end in March 2016. The research will be conducted in stages and, if and when GALVmed decides to commence research on each stage, it will pay the Company’s budgeted research costs for such stage in advance. The Company will record such advance payments as deferred revenue and recognize the related research contract revenues as it performs the research for each stage. Upon execution of the GALVmed agreement, the Company was entitled to receive advance payments totaling $0.8 million for the first stages of research and recorded this amount as deferred revenue. As of September 30, 2014, the Company had current deferred revenue related to these advance payments of $0.6 million.

 

Revenues recognized under the GALVmed collaboration agreement were as follows (in thousands):

 

 

 

Three Months
Ended September 30,

 

Nine Months
Ended September 30,

 

 

 

2014

 

2014

 

 

 

(unaudited)

 

Research contract revenue:

 

 

 

 

 

Research funding

 

$

205

 

$

205

 

Total research contract revenue

 

$

205

 

$

205

 

 

DTRA

 

In October 2013, the Company entered into a research agreement with DTRA to design and discover new classes of systemic antibiotics. A drug discovery consortium led by the Company is conducting the research over a period of up to three and a half years. The work is funded by an award of up to $13.5 million from DTRA’s R&D Innovation and Systems Engineering Office, which was established to search for and execute strategic investments in innovative technologies for combating weapons of mass destruction. Under this award, the Company will apply its boron chemistry to discover rationally designed novel antibiotics that target DTRA-priority pathogens known to exhibit resistance to existing antibiotics. The award was initially available to the consortium to fund $2.7 million of research reimbursements for the eleven month period through September 15, 2014, with an additional $5.0 million and $5.7 million becoming available subject to the exercise by DTRA of options to fund the research for subsequent twelve and nineteen month periods, respectively. In August 2014, DTRA exercised the first option to fund the twelve month research extension.

 

Revenues recognized under the research agreement were as follows (in thousands):

 

 

 

Three Months
Ended September 30,

 

Nine Months
Ended September 30,

 

 

 

2014

 

2014

 

 

 

(unaudited)

 

Research contract revenue:

 

 

 

 

 

Research funding

 

$

579

 

$

2,434

 

Total research contract revenue

 

$

579

 

$

2,434

 

 

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Gates Foundation

 

In April 2013, the Company entered into a research agreement with the Gates Foundation to discover drug candidates intended to treat two filarial worm diseases (onchocerciasis, or river blindness, and lymphatic filariasis, commonly known as elephantiasis) and TB (the Gates Research Agreement). Under the Gates Research Agreement, the Gates Foundation will pay the Company up to $17.7 million over a three-year research term (the Research Funding) to conduct research activities directed at discovering potential neglected disease drug candidates in accordance with an agreed upon research plan. As part of the funded research activities, the Company is also responsible for creating, during the first 18 months following execution of the Gates Research Agreement, an expanded library of boron compounds to screen for additional potential drug candidates to treat neglected diseases (the Library). Once the Library is completed, the Company is responsible for storing the Library compounds and making them accessible to the Gates Foundation and other parties to which the Gates Foundation grants access (the Library Access Services) for the subsequent five-year period.

 

Upon signing the Gates Research Agreement, the Company received an advance payment of $1.75 million of Research Funding (the Advance Funds). These Advance Funds are replenished by the Gates Foundation each quarter following the Company’s submission of a quarterly report of the expenses incurred for the research activities conducted in the prior quarter. In addition, the Gates Foundation paid the Company a total of $0.8 million as reimbursement for the costs of filarial worm research that was included in the agreed upon research plan, which the Company conducted prior to the April 5, 2013 effective date of the Gates Research Agreement (the Pre-Contract Reimbursements). These Pre-Contract Reimbursements are non-refundable, non-creditable payments and were included in the $17.7 million of Research Funding.

 

Under the terms of the agreement, the Gates Foundation will have the exclusive right to commercialize selected drug candidates in specified neglected diseases in specified developing countries. The Company retains the exclusive right to commercialize any selected drug candidate outside of the specified neglected diseases as well as with respect to the specified neglected diseases in specified developed countries and would be obligated to pay the Gates Foundation royalties on specified license revenue received. The Gates Research Agreement will continue in effect until the later of five years from the effective date or the expiration of the Company’s specified obligation to provide access to the Library. Either party may terminate the Gates Research Agreement for the other party’s uncured material breach of the Gates Research Agreement.

 

In connection with the Gates Research Agreement, the Company entered into a Common Stock Purchase Agreement (the Purchase Agreement) pursuant to which the Company issued 809,061 shares of potentially redeemable common stock to the Gates Foundation for net proceeds of approximately $5.0 million (the Stock Proceeds)  (see Note 9). In addition, in connection with both the Gates Research Agreement and the Purchase Agreement, the Company and the Gates Foundation entered into a letter agreement (the Letter Agreement) that, among other things, restricts the Company’s use of both the Research Funding and the Stock Proceeds to expenditures, including an allocation of overhead and administrative expenses, that are reasonably attributable to the activities that are required to support the research projects funded by the Gates Foundation. As a result of such restrictions, in its September 30, 2014 condensed consolidated balance sheet, the Company classified $2.1 million of the Stock Proceeds as long-term restricted investments and $1.0 million of the Stock Proceeds plus the unspent portion of the Advance Funds, approximately $0.1 million, as short-term restricted investments.

 

The Company evaluated the Gates Research Agreement under the accounting guidance for multiple-element arrangements and identified three deliverables: the research activities, the 5-year Library Access Services and the obligation to participate in the joint steering committee. Although participation in the joint steering committee has stand-alone value, it will be delivered as the research activities are performed and has a similar pattern of performance. Accordingly, the Company has combined this deliverable with the research activities deliverable as a single unit of accounting. The Company developed its best estimates of selling prices (BESP) for each deliverable in order to allocate the arrangement consideration to the two units of accounting. The Company determined the BESP for the research activities based on factors such as estimated direct expenses and other costs involved in providing these services, the contractually agreed reimbursement rates for the services and the rates it has charged and the margins it has realized under its other contracts involving the provision of and reimbursement for research services. The Company determined the BESP for the Library Access Services based on the projected costs that would be incurred to have a third party store and distribute the library compounds and the estimated costs

 

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that would be incurred to provide the Library Access Services for the required 5-year period, plus a reasonable margin, and concluded that the BESP of such services is insignificant. As a result, the entire arrangement consideration was allocated to the research activities and joint steering committee combined unit of accounting. The Company will recognize revenue related to this unit of accounting on a proportional performance basis and the revenue that is recognized as future research services are performed will reduce the Advance Funds. The unspent portion of the Advance Funds will be recorded as deferred revenue in the Company’s condensed consolidated balance sheets.

 

The Company also evaluated the accounting treatment for the $0.8 million of Pre-Contract Reimbursements, noting that the research activities that gave rise to such reimbursements were conducted prior to the signing of the Gates Research Agreement. The Company concluded that activities performed prior to commencing delivery of the contracted services should not be considered in effort-expended measures of performance when revenue is recognized for services using a proportional performance method and, accordingly, the Company will recognize revenue from the Pre-Contract Reimbursements over the three-year research term on a proportional performance basis. As of September 30, 2014, the Company has deferred revenue of $0.1 million related to the unspent Advance Funds and $0.3 million related to the Pre-Contract Reimbursements.

 

Revenues recognized under the Gates Research Agreement were as follows (in thousands):

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Research contract revenue:

 

 

 

 

 

 

 

 

 

Amortization of Pre-Contract Reimbursements

 

$

76

 

$

73

 

$

216

 

$

128

 

Reimbursement for research costs

 

1,687

 

1,618

 

4,832

 

2,865

 

Total research contract revenue

 

$

1,763

 

$

1,691

 

$

5,048

 

$

2,993

 

 

GSK

 

In September 2011, the Company amended and expanded its 2007 research and development collaboration with GSK (the Master Amendment) to, among other things, give effect to certain rights in AN3365 that would be acquired by the U.S. government in connection with GSK’s contract for government funding to support GSK’s further development of AN3365, provide GSK the option to extend its rights around the bacterial enzyme target leucyl-tRNA synthetase (LeuRS), as well as to add new programs for tuberculosis (TB) and malaria using the Company’s boron chemistry platform. As a result of the Master Amendment, the Company received a $5.0 million upfront payment in September 2011 and was eligible to receive additional milestone payments, bonus payments and research funding as described below, all of which, if earned, will be non-refundable and non-creditable. The Company is also eligible to receive royalties on future sales of resulting products. The Master Amendment also terminated any research and development obligations that the Company had with respect to the original agreement.

 

Under the terms of the Master Amendment, GSK retained sole responsibility for the further development and commercialization of AN3365. In October 2012, GSK advised the Company that it had discontinued further development of AN3365; accordingly, all rights to the compound have reverted to the Company.

 

The Master Amendment added a new program for TB, pursuant to which GSK funded the Company’s TB research activities up until candidate selection. Once TB compounds met specified candidate selection criteria, GSK had the option to license such compounds and, upon exercise of such option, would become responsible for all further development and commercialization of such compounds.

 

In September 2013, GSK selected a compound that resulted from the TB program which is currently in preclinical development. The research period under the collaboration agreement with GSK has expired. GSK will be responsible for all further development and commercialization of the TB compound previously selected by it, and the Company may receive contingent payments, if certain regulatory events occur and/or if certain sales levels are achieved for resulting TB products, and may also receive royalties on sales of such resulting products. As of September 30, 2014, the Company has no deferred revenue associated with the GSK collaboration agreement.

 

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Revenues recognized under this agreement were as follows (in thousands):

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Research contract revenue:

 

 

 

 

 

 

 

 

 

Reimbursement for research and patent costs

 

$

115

 

$

360

 

$

149

 

$

1,047

 

Total research contract revenue

 

$

115

 

$

360

 

$

149

 

$

1,047

 

 

Lilly

 

In August 2010, the Company entered into a research, license and commercialization agreement with Lilly to collaborate on the discovery of products for a variety of animal health applications. Lilly will be responsible for worldwide development and commercialization of compounds advancing from these efforts. The Company received an upfront payment of $3.5 million in September 2010, which it had been recognizing over the expected four-year research term on a straight-line basis. The agreement allowed for termination by Lilly upon written notice, with certain additional payments to the Company and a notice period that had a duration dependent on whether the notice was delivered prior to or after the first regulatory approval of a product under the agreement.

 

In January 2014, Lilly notified the Company of the termination of the research term of the agreement. The termination of the funding for the agreement became effective 90 days after the Company’s receipt of the termination notice and ended Lilly’s obligation to make quarterly research payments. As a result of the termination notice, the Company revised the expected research term to end in April 2014, approximately five months earlier than estimated at the inception of the agreement. The remainder of the agreement remains in effect and Lilly retained its exclusive rights to the development of one of the two compounds it licensed from the Company (as described further below).

 

In 2011 and 2012, Lilly licensed two development compounds from the Company and the Company was eligible to receive additional payments upon the occurrence of specified development and regulatory events for these compounds. The Company has determined that none of these contingent payments are substantive milestones. To date, no products have been approved and therefore no royalties have been earned under this agreement. In September 2013, Lilly notified the Company that it was ceasing further development of one of the two previously licensed compounds; Lilly granted the Company a fully paid, sublicenseable, perpetual, irrevocable, exclusive license to the related technology and patents.

 

As of September 30, 2014, the Company has no deferred revenue related to the upfront fee or research term funding.

 

Revenues recognized under the agreement and for other research services were as follows (in thousands):

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Research contract revenue:

 

 

 

 

 

 

 

 

 

Amortization of upfront fee

 

$

 

$

219

 

$

480

 

$

656

 

Research funding

 

 

810

 

800

 

2,445

 

Total research contract revenue

 

$

 

$

1,029

 

$

1,280

 

$

3,101

 

 

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Medicines for Malaria Venture

 

In March 2011, the Company entered into a three-year development agreement with Medicines for Malaria Venture (MMV) to collaborate on the development of compounds for the treatment of malaria through human proof-of-concept studies. This development agreement was preceded by a 2010 research agreement between the two parties. In August 2011, the Company and MMV amended the development agreement to, among other things, specify that any advance payments in excess of the actual costs incurred by the Company for the research and development activities under the agreement are either refundable or creditable against future payments, at MMV’s option. In January 2014, the research agreement was amended and extended through December 31, 2014. Under the amended agreement, MMV reimburses the Company quarterly in arrears for expenses incurred. As of September 30, 2014, the Company had no deferred revenue associated with its agreements with MMV.

 

Revenues recognized under the MMV research and development agreement were as follows (in thousands):

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Research contract revenue:

 

 

 

 

 

 

 

 

 

Research funding

 

$

122

 

$

10

 

$

391

 

$

301

 

Total research contract revenue

 

$

122

 

$

10

 

$

391

 

$

301

 

 

9. Potentially Redeemable Common Stock and Stockholders’ Equity

 

Potentially Redeemable Common Stock

 

In connection with the Gates Research Agreement (see Note 8), the Company entered into the Purchase Agreement with the Gates Foundation pursuant to which the Company issued 809,061 shares of its common stock at a purchase price of $6.18 per share on April 5, 2013. Net proceeds to the Company from this offering were approximately $5.0 million, after deducting offering expenses of $48,000. On June 28, 2013, the Company filed a registration statement on Form S-3 with the SEC, which became effective on July 11, 2013, to register the resale of the 809,061 shares of common stock. In the event of termination of the Gates Research Agreement by the Gates Foundation for certain specified uncured material breaches by the Company (the Triggering Events), the Company will be obligated, among other remedies, to redeem for cash the Company’s common stock purchased in connection with the Gates Research Agreement, facilitate the purchase of such common stock by a third party or elect to register the resale of such common stock into the public markets unless certain specified conditions are satisfied. The redemption price per share would be the fair value per share of the Company’s common stock on the redemption date or, under certain circumstances, the greater of (i) the fair value per share and (ii) the purchase price of $6.18 per share plus interest at 5% compounded annually from April 5, 2013, the stock purchase date. In connection with both the Gates Research Agreement and the Purchase Agreement, the Company and the Gates Foundation also entered into the Letter Agreement that, among other things, places certain restrictions on the use of both the Research Funding and the Stock Proceeds (see Note 8).

 

The Company concluded that certain of these Triggering Events are not solely within the control of the Company and, accordingly, has classified the potentially redeemable securities outside of permanent equity in temporary equity. The 809,061 shares of common stock issued were recorded as potentially redeemable common stock at an initial carrying amount equal to the net proceeds of approximately $5.0 million, which approximates their issuance date fair value.

 

The Company has determined that the 809,061 shares of potentially redeemable common stock are not currently redeemable and that none of the Triggering Events are currently probable. Accordingly, the carrying amount of the potentially redeemable common stock remains at approximately $5.0 million as of September 30, 2014. Only if, and when, a Triggering Event becomes probable will the Company record a change in the carrying amount to adjust it to the redemption value of the potentially redeemable common stock. At the time of such an occurrence, the potentially redeemable common stock will be immediately adjusted, by a credit or charge to other income or expense, to equal the redemption value and will continue to be adjusted to reflect any change in the redemption value as of the end of each reporting period.

 

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Shelf Registration Statement

 

In August 2013, the Company filed a shelf registration statement on Form S-3 with the SEC (the Shelf Registration Statement). The Shelf Registration Statement was declared effective by the SEC and permits the Company to sell, from time to time, up to $50.0 million of common stock, preferred stock, debt securities and warrants.

 

Preferred Stock

 

In November 2010, the Company amended and restated its certificate of incorporation to authorize 10,000,000 shares of preferred stock upon the completion of its Initial Public Offering (IPO). As of September 30, 2014 and December 31, 2013, no shares of preferred stock were outstanding.

 

10. Stock-Based Compensation

 

The Company recorded stock-based compensation expense for the three and nine months ended September 30, 2014 and 2013 as follows (in thousands):

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

2014(1)

 

2013

 

 

 

(unaudited)

 

(unaudited)

 

Cost of goods sold

 

$

9

 

$

 

$

9

 

$

 

Research and development

 

1,519

 

744

 

3,853

 

1,910

 

Selling, general and administrative

 

2,149

 

545

 

7,742

 

1,393

 

Total

 

$

3,677

 

$

1,289

 

$

11,604

 

$

3,303

 

 


(1) Includes $3.0 million of expense relating to the modification of options held by the Company’s prior chief executive officer upon his resignation. See discussion of Stock Option Modification below.

 

For the three and nine months ended September 30, 2014, the Company issued  828,859 and 1,012,705 shares of the Company’s common stock and received approximately $6.2 million and $7.0 million, respectively, in cash from the exercise of stock options. Total stock options (including Performance Stock Options (PSOs) as described below) granted for the three and nine months ended September 30, 2014 were 90,318 options (which included 20,818 options granted to nonemployee advisors) and 1,876,946 options (which included 33,646 options granted to nonemployee advisors), respectively. Grants to nonemployee advisors do not include grants made to the Company’s nonemployee directors for their board-related services. The weighted-average fair value per share of options, other than PSOs, granted to employees and the Company’s nonemployee directors was $17.05 and $13.72 for the three and nine months ended September 30, 2014, respectively.

 

At September 30, 2014, there were outstanding stock options to purchase 5,088,382 shares of the Company’s common stock. At September 30, 2014, the Company had $27.6 million and $0.2 million of unrecognized compensation expense, net of estimated forfeitures, related to outstanding stock option and restricted stock unit awards and Employee Stock Purchase Program (ESPP) stock purchase rights, respectively, that will be recognized over a weighted-average period of 3.0 years and 0.6 years, respectively. For the three and nine months ended September 30, 2014, there were 45,656 and 88,719 shares of the Company’s common stock purchased under the ESPP, respectively.

 

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Stock Option Modification

 

In connection with the resignation of the Company’s former chief executive officer in March 2014, the Company’s board of directors approved an additional 18 months of vesting for his unvested stock options, or 223,542 stock options. These stock options would have otherwise expired upon termination. The Company’s board of directors also approved the extension of the post-termination period for the exercise of his vested stock options from three months to six months. As a result of these modifications, during the three months ended March 31, 2014, the Company recorded a one-time stock-based compensation expense of $3.0 million for the incremental value of the stock options vested and the extension of the post-termination exercise period.

 

Restricted Stock Units (RSUs), Performance Restricted Stock Units (PRSUs) and PSOs

 

During the nine months ended September 30, 2014, the Company began issuing time-based vesting RSUs and market-based vesting PRSUs and PSOs. RSU and PRSU grants cannot be transferred, and until they vest, the underlying shares are subject to forfeiture if the grantee’s service with the Company terminates prior to the release of the applicable vesting restrictions. The Company uses a Monte Carlo valuation method to estimate the fair value of market-based vesting PRSU and PSO grants. Time-based vesting RSUs are valued at the closing price of the Company’s common stock on the date of grant. The vesting conditions applicable to the Company’s outstanding RSUs, PRSUs and PSOs are as follows:

 

·                  One-fourth of the RSU grants will vest on each of the first four anniversaries of the applicable vesting commencement date, subject to the grantee’s continued service with the Company. Upon vesting of RSUs, the Company will issue to the grantee thereof one share of the Company’s common stock for each such RSU.

 

·                  Grants of PRSUs and PSOs made during the nine months ended September 30, 2014 will vest in full, subject to the grantee’s continued service with the Company, if at any time during the four-year period beginning March 21, 2014, the volume-weighted average price for the Company’s common stock exceeds $30 per share (using the VAP function on Bloomberg for the Company “ANAC US EQUITY VAP”, or successor thereof) for 30 consecutive trading days. If such vesting condition is not met within such four-year period, such PRSU and PSO grants will expire. Once vested, each PSO provides the grantee with the right to purchase one share of the Company’s common stock at the applicable option exercise price. Upon vesting of PRSUs, the Company will issue to the grantee thereof one share of the Company’s common stock for each such PRSU.

 

Such RSUs, PSOs and PRSUs are also subject to accelerated vesting in the event of certain terminations in connection with a change of control. The weighted-average fair values for these PSOs and PRSUs granted during the nine months ended September 30, 2014 were determined using Monte Carlo simulation models incorporating the following weighted-average assumptions:

 

 

 

Nine Months Ended
September 30, 2014

 

 

 

PSOs

 

PRSUs

 

 

 

(unaudited)

 

Number of PSOs or PRSUs granted

 

100,000

 

50,000

 

Exercise price

 

$

21.21

 

N/A

 

Risk-free interest rate

 

1.32

%

1.32

%

Volatility

 

60.20

%

60.20

%

Dividends

 

 

 

Weighted-average fair value per share of PSOs or PRSUs granted

 

$

9.82

 

$

17.87

 

 

The Company will recognize the estimated expense of these PSOs and PRSUs, as determined under the simulation models, over the expected life of the award, with no adjustment in future periods based upon the Company’s actual stock price over the performance period.

 

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For the nine months ended September 30, 2014, the Company granted 397,000 RSUs, 50,000 PRSUs and 100,000 PSOs. There were no PRSU or PSO grants made during the three months ended June 30, 2014 and no RSU, PRSU or PSO grants made during the three months ended September 30, 2014.

 

11. Trademark Agreement

 

In September 2014, the Company entered into a coexistence and release agreement relating to the Company’s KERYDIN trademark (the Trademark Agreement). Pursuant to the Trademark Agreement, the parties thereto, among other things, acknowledged, on a worldwide basis, the respective rights of each party to certain trademarks, including KERYDIN in the case of the Company. In connection with the Trademark Agreement, the Company paid $6.8 million to an unaffiliated third party and such third party granted the Company, Sandoz and, among others, their respective representatives, manufacturers, distributors, suppliers, licensees, marketing partners and customers a full release from any claims by such third party relating to the use of the KERYDIN trademark.

 

12. Subsequent Events

 

On October 16, 2014, the Company issued and sold $90.5 million aggregate principal amount of 2.00% Convertible Senior Notes due 2021 (the Convertible Notes), comprised of (i) $82.5 million aggregate principal amount of Convertible Notes sold to certain initial purchasers for resale to qualified institutional buyers in a private offering exempt from registration under the Securities Act of 1933, as amended (the Securities Act), in reliance upon Rule 144A under the Securities Act (including $7.5 million aggregate principal amount of Convertible Notes issued upon the exercise in full of the over-allotment option granted to such initial purchasers) and (ii) $8.0 million aggregate principal amount of Convertible Notes (the Venrock Notes) sold in a concurrent private placement under the Securities Act to certain funds affiliated with Venrock Associates (the Venrock Funds), an affiliate of the Company. The Company received total net proceeds from the sale of the Convertible Notes of approximately $87.6 million, after deducting the initial purchasers’ fees of $2.9 million. The Company used approximately $30.8 million of the net proceeds from the sale of the Convertible Notes to repay in full its outstanding indebtedness under, and terminate, the Loan Agreement (see Note 7) and intends to use the remaining net proceeds for general corporate purposes.

 

The Convertible Notes were issued pursuant to an indenture, dated as of October 16, 2014 (the Indenture), by and between the Company and Wells Fargo Bank, National Association, as trustee. The Convertible Notes are general unsecured obligations of the Company, bear interest at a fixed rate of 2.00% per year (payable semiannually in arrears on April 15 and October 15 of each year, beginning on April 15, 2015) and will mature on October 15, 2021, unless earlier purchased, redeemed or converted. Subject to satisfaction of certain conditions and during certain periods, the Convertible Notes will be convertible at the option of holders into cash, shares of the Company’s common stock or a combination thereof, at the Company’s election. The conversion rate will initially be 32.2061 shares of common stock per $1,000 principal amount of Convertible Notes (equivalent to an initial conversion price of approximately $31.05 per share of the Company’s common stock). The conversion rate and the corresponding conversion price will be subject to adjustment upon the occurrence of certain events, but will not be adjusted for any accrued and unpaid interest. If the Company undergoes a fundamental change (as defined in the Indenture), holders may require the Company to purchase for cash all or part of their Convertible Notes at a purchase price equal to 100% of the principal amount of the Convertible Notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the fundamental change purchase date. In addition, if certain make-whole fundamental changes occur or if the Company issues a notice of redemption for the Convertible Notes, the Company will, in certain circumstances, increase the conversion rate for any Convertible Notes converted in connection with such make-whole fundamental change or notice of redemption. The Convertible Notes will not be redeemable at the Company’s option prior to October 15, 2018. On or after October 15, 2018, the Convertible Notes will be redeemable at the Company’s option if the last reported sale price of the Company’s common stock for at least 20 trading days in any 30 trading day period exceeds 130% of the conversion price for the Convertible Notes. The Indenture provides for customary events of default.

 

In connection with the sale of the Venrock Notes, the Company entered into a registration rights agreement with the Venrock Funds, pursuant to which the Venrock Funds may require the Company, from and after the one-year anniversary of the last date of original issuance of the Venrock Notes, to register the resale by the Venrock Funds of the Venrock Notes, any shares of the Company’s common stock issuable to the Venrock Funds upon conversion of the Venrock Notes or any other securities that may be issued or distributed in respect of such Venrock Notes or shares by way of conversion, dividend, stock split or other distribution or specified corporate transactions.

 

On October 8, 2014, the Company terminated its equity distribution agreement with Wedbush Securities Inc. (Wedbush), pursuant to which the Company was previously able to offer and sell, from time to time, up to $25.0 million of its common stock through Wedbush for resale.

 

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ITEM 2.                        MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

You should read the following discussion and analysis together with our condensed consolidated financial statements and the notes to those statements included elsewhere in this Quarterly Report on Form 10-Q and in our other Securities and Exchange Commission (SEC) filings, including our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the SEC on March 17, 2014. This discussion contains forward-looking statements that involve risks and uncertainties. We use words such as “may,” “will,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “predict,” “potential,” “believe,” “should” and similar expressions to identify forward-looking statements. These statements appearing throughout this Quarterly Report on Form 10-Q are statements regarding our intent, belief, or current expectations, primarily regarding our operations. You should not place undue reliance on these forward-looking statements, which apply only as of the date of this Quarterly Report on Form 10-Q. As a result of many factors, such as those set forth under “Risk Factors” and elsewhere in this Quarterly Report on Form 10-Q, our actual results may differ materially from those anticipated in these forward-looking statements. Unless otherwise noted or the context otherwise requires, references in this Quarterly Report on Form 10-Q to “we,” “us” or “our” refer to Anacor Pharmaceuticals, Inc. and its subsidiary.

 

Overview

 

We are a biopharmaceutical company focused on discovering, developing and commercializing novel small-molecule therapeutics derived from our boron chemistry platform. Our first approved drug, KERYDINTM (tavaborole) topical solution, 5% (formerly known as AN2690), is an oxaborole antifungal approved by the U.S. Food and Drug Administration (FDA) in July 2014 for the topical treatment of onychomycosis of the toenails. In July 2014, we entered into an exclusive Distribution and Commercialization Agreement (the Sandoz Agreement) with Sandoz Inc. (together with its affiliates, Sandoz), a Novartis company, pursuant to which Sandoz distributes and commercializes KERYDIN in the United States.  In September 2014, KERYDIN was launched in the United States by Sandoz pursuant to the Sandoz Agreement.   Our lead product candidate is AN2728, an investigational non-steroidal topical PDE-4 inhibitor in development for the potential treatment of mild-to-moderate atopic dermatitis and psoriasis.  We initiated Phase 3 studies of AN2728 for the treatment of mild-to-moderate atopic dermatitis in the first quarter of 2014.

 

Beyond KERYDIN and AN2728, we have discovered three investigational compounds that we have out-licensed for further development. The first compound is licensed to Eli Lilly and Company (Lilly) for the potential treatment of an animal health indication.  The second compound, AN5568, is licensed to Drugs for Neglected Diseases initiative (DNDi) for the potential treatment of human African trypanosomiasis (HAT, or sleeping sickness) and the third compound is licensed to GlaxoSmithKline LLC (GSK) for development in tuberculosis (TB). We also have a pipeline of other internally discovered topical and systemic boron-based compounds in early stages of research and development. These include three wholly-owned investigational product candidates. AN2718 is an investigational topical antifungal, AN2898 is an investigational non-steroidal topical PDE-4 inhibitor and AN3365 is an investigational Gram-negative antibiotic.

 

Recent Developments

 

Pursuant to the above-described Sandoz Agreement, we received two upfront payments totaling $40.0 million during the three months ended September 30, 2014.  We also expect to receive a payment of $25.0 million in January 2015.  Under the Sandoz Agreement, we are entitled to 50% of the gross profits (defined as net sales less cost of goods sold) accrued by Sandoz on sales of KERYDIN, except that in 2015 we will start receiving gross profit sharing payments after the first $50.0 million of gross profits have been accrued by Sandoz. The gross profit sharing arrangement entitles us to cumulative minimum gross profit sharing payments totaling $45.0 million for 2016.  We are not entitled to cumulative minimum gross profit sharing payments in any other year under the Sandoz Agreement. Under the terms of the Sandoz Agreement, we hold the New Drug Application (NDA) for, and are responsible for any further development of, KERYDIN. Sandoz is responsible for setting the price for KERYDIN and for all of its selling, marketing, distribution, general and administrative costs related to the commercialization of KERYDIN.  We are also responsible for supplying KERYDIN to Sandoz under the Sandoz Agreement at a price equal to our manufacturing costs therefor (as calculated pursuant to the Sandoz Agreement), and are currently supplying Sandoz with KERYDIN manufactured by our contract manufacturers.  The Sandoz Agreement also grants us an option to repurchase all rights in KERYDIN from Sandoz on the later of three years from launch or December 31, 2017, at a price to be determined pursuant to the Sandoz Agreement. The Sandoz Agreement will continue for an initial term of five years and is subject to automatic five-year renewal terms, unless terminated for certain events specified in the Sandoz Agreement.

 

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In July 2014, the FDA approved the NDA for KERYDINTM (tavaborole) topical solution, 5% for the topical treatment of onychomycosis of the toenails.

 

In October 2013, we entered into a research agreement with the United States Department of Defense, Defense Threat Reduction Agency (DTRA) to design and discover new classes of systemic antibiotics. A drug discovery consortium led by us is conducting the research over a period of up to three and a half years. The work is funded by an award of up to $13.5 million from DTRA’s R&D Innovation and Systems Engineering Office, which was established to search for and execute strategic investments in innovative technologies for combating weapons of mass destruction. Under this award, we will apply our boron chemistry to discover rationally designed novel antibiotics that target DTRA-priority pathogens known to exhibit resistance to existing antibiotics. The award was initially available to the consortium to fund $2.7 million of research reimbursements for the eleven month period through September 15, 2014, with an additional $5.0 million and $5.7 million becoming available subject to the exercise by DTRA of options to fund the research for subsequent twelve and nineteen month periods, respectively. In August 2014, DTRA exercised the first option to fund the twelve month research extension.

 

In April 2013, we entered into a research agreement with The Bill & Melinda Gates Foundation (the Gates Foundation) to discover drug candidates intended to treat two filarial worm diseases (onchocerciasis, or river blindness, and lymphatic filariasis, commonly known as elephantiasis) and TB. Under the research agreement, the Gates Foundation will pay us up to $17.7 million over a three-year research term to conduct research activities directed at discovering potential neglected disease drug candidates in accordance with an agreed upon research plan. As part of the funded research activities, we are responsible for creating an expanded library of boron compounds to screen for additional potential drug candidates to treat neglected diseases, which will be accessible to the Gates Foundation and other third parties. Under the terms of the agreement, the Gates Foundation will have the exclusive right to commercialize selected drug candidates in specified neglected diseases in specified developing countries. We retain the exclusive right to commercialize any selected drug candidate outside of the specified neglected diseases as well as with respect to the specified neglected diseases in specified developed countries and would be obligated to pay the Gates Foundation royalties on specified license revenue received. The agreement will continue in effect until the later of five years from the effective date or the expiration of our specified obligation to provide access to the expanded library of boron compounds. In connection with the research agreement, we issued 809,061 shares of potentially redeemable common stock to the Gates Foundation for net proceeds of approximately $5.0 million. In the event of termination of the research agreement by the Gates Foundation for certain specified uncured material breaches by us, we will be obligated, among other remedies, to redeem for cash our common stock purchased in connection with the research agreement, facilitate the purchase of such common stock by a third party or elect to register the resale of such common stock into the public markets unless certain specified conditions are satisfied. In addition, we are subject to certain restrictions on our use of the potentially redeemable common stock proceeds and the research funding we receive from the Gates Foundation.

 

In September 2011, we amended and expanded our 2007 research and development collaboration with GSK to, among other things, add a new research program using our boron chemistry platform for TB. In September 2013, GSK selected a compound that resulted from the TB program which is currently in preclinical development. The research period under the agreement with GSK has expired.  GSK will be responsible for all further development and commercialization of the TB compound previously selected by it.

 

In August 2010, we entered into a research, license and commercialization agreement with Lilly to collaborate on the discovery of products for a variety of animal health applications. Pursuant to this agreement, Lilly licensed a development compound from us in December 2012 and will be responsible for all further development and commercialization of this compound. In January 2014, Lilly notified us of the termination of the research term of the agreement, effective April 2014, which was approximately five months earlier than the research period was originally expected to end. The remainder of the agreement, including provisions related to potential future payments and royalties, remains in effect and Lilly retains its exclusive rights to the development of the licensed compound.

 

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We also have several collaborations with organizations that fund research leveraging our boron chemistry to discover new treatments for neglected diseases. In addition to potentially developing new therapies for such diseases, these collaborations provide us the potential benefits of expanding the chemical diversity of our boron compounds, understanding new properties of our boron compounds, receiving future incentives, such as the potential grant of a priority review voucher by the FDA, and ultimately, if a drug is approved, potential revenue in some regions. Our collaboration partners include DNDi to develop new therapeutics for sleeping sickness, visceral leishmaniasis and Chagas disease, Medicines for Malaria Venture (MMV) to develop compounds for the treatment of malaria, the Global Alliance for Livestock Veterinary Medicines (GALVmed) for the treatment of animal trypanosomiasis and the Liverpool School of Tropical Medicine for the treatment of river blindness and lymphatic filariasis. In 2011, DNDi completed pre-clinical studies of AN5568 for sleeping sickness and, in March 2012, AN5568 became the first compound from our neglected diseases initiatives to enter human clinical trials. The AN5568 Phase 1 clinical trial is currently in its final stages and, depending upon the results of that trial, a Phase 2/3 registration trial could be initiated as early as the first half of 2015.

 

Recent Capital Markets and Financing Activities and Litigation Settlement

 

In October 2014, we issued and sold $90.5 million aggregate principal amount of 2.00% Convertible Senior Notes due 2021 (the Convertible Notes), comprised of (i) $82.5 million aggregate principal amount of Convertible Notes sold to certain initial purchasers for resale to qualified institutional buyers in a private offering exempt from registration under the Securities Act of 1933, as amended (the Securities Act), in reliance upon Rule 144A under the Securities Act (including $7.5 million aggregate principal amount of Convertible Notes issued upon the exercise in full of the over-allotment option granted to such initial purchasers) and (ii) $8.0 million aggregate principal amount of Convertible Notes sold in a concurrent private placement under the Securities Act to certain funds affiliated with Venrock Associates, an affiliate of ours.  We received total net proceeds from the sale of the Convertible Notes of approximately $87.6 million, after deducting the initial purchasers’ fees of $2.9 million.  We used approximately $30.8 million of the net proceeds from the sale of the Convertible Notes to repay in full our outstanding indebtedness under, and terminate, our loan and security agreement (the Loan Agreement) with Hercules Technology Growth Capital, Inc. and Hercules Technology III, L.P. (together, Hercules) and intend to use the remaining net proceeds for general corporate purposes.

 

In October 2014, we terminated our January 2013 equity distribution agreement with Wedbush Securities Inc. (Wedbush), pursuant to which we were previously able to offer and sell, from time to time, up to $25.0 million of our common stock through Wedbush for resale.  Prior to its termination, we had sold shares of our common stock under this agreement generating net proceeds of approximately $1.3 million, after deducting underwriting discounts and other offering costs. No shares were sold under this agreement during the nine months ended September 30, 2014.

 

In October 2013, we entered into a settlement agreement with Valeant Pharmaceuticals International, Inc. (Valeant) and Dow Pharmaceutical Sciences, Inc. (DPS), which was acquired by Valeant in December 2008, pursuant to which Valeant agreed to pay us $142.5 million to settle all existing and future claims and all other disputes between Valeant, DPS and us related to our intellectual property, confidential information and contractual rights, including the breach of contract dispute that we initiated under a master services agreement that we entered into with DPS in March 2004. In addition, we and Valeant, which acquired Medicis Pharmaceutical Corporation (Medicis) in December 2012, agreed to withdraw all claims and complaints relating to arbitration or litigation in connection with a research and development option and license agreement that we entered into with Medicis in February 2011 (the Medicis Agreement), to terminate the Medicis Agreement effective immediately and to cause all rights and intellectual property under the Medicis Agreement to revert to us.

 

In June 2013, we entered into the Loan Agreement, which provided for loans to us of up to $45.0 million. The first $30.0 million tranche was drawn at the closing of the transaction, at which time we repaid $22.6 million in remaining obligations associated with our then-existing loan facility. We elected not to draw the second tranche of $10.0 million, which was available to us from the closing date of the Loan Agreement until December 5, 2013. We also elected not to draw the third tranche of $5.0 million, which was available to us from the date of FDA approval of KERYDIN until August 6, 2014.  In October 2014, we used approximately $30.8 million of the net proceeds from the sale of Convertible Notes to repay in full our outstanding indebtedness under, and terminate, the Loan Agreement.

 

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In May 2013, we issued and sold 3,599,373 shares of our common stock, including 469,483 shares issuable pursuant to the exercise of an overallotment option, in a registered public offering. Our net proceeds from this offering were approximately $21.3 million, after deducting underwriting discounts and other offering costs.

 

Critical Accounting Policies and Significant Judgments and Estimates

 

Our management’s discussion and analysis of our financial condition and results of operations is based on our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments in certain circumstances that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments, including those related to revenue recognition, fair values of financial instruments in which we invest, inventory, income taxes, preclinical study and clinical trial accruals, accrued compensation, other contingencies and stock-based compensation. We base our estimates on historical experience and on various other factors that we believe to be reasonable under the circumstances and review our estimates on an ongoing basis. Actual results may differ from these estimates under different assumptions or conditions.

 

There have been no significant changes during the nine months ended September 30, 2014 to our critical accounting policies and significant judgments and estimates as disclosed in our management’s discussion and analysis of financial condition and results of operations included in our Annual Report on Form 10-K for the year ended December 31, 2013, with the exception of those related to inventory, revenue recognition for distribution and commercialization agreements and stock-based compensation, which are discussed in greater detail below.

 

Inventory

 

Inventories are stated at the lower of cost or market. Cost is determined using the first-in, first-out (FIFO) method for all inventories, which are valued based on costs calculated for each production batch. We periodically evaluate the carrying value of inventory on hand for potential excess quantities and obsolescence. As a result of such evaluations, no charges were recorded in the three or nine months ended September 30, 2014.

 

Revenue Recognition

 

Arrangements under which we grant another party distribution and commercialization rights to one of our products and that involve multiple other deliverables are evaluated based on the accounting guidance for multiple-element arrangements to determine whether any of the deliverables qualifies as a separate unit of accounting. If we determine that the deliverables do not have stand alone value because each one of them has value only as it relates to maintaining and supporting the other party’s distribution and commercialization rights, then all deliverables are combined as a single unit of accounting, all arrangement consideration is allocated to that combined unit of accounting and revenues are recognized based on the performance requirements of the related agreement.  Upfront payments received under such agreements are recorded as deferred revenue in the condensed consolidated balance sheets and are recognized as distribution and commercialization agreement revenue ratably over the contractual or estimated performance period that is consistent with the term of our obligations under the agreement. If any deliverable is determined to have stand-alone value to the customer, it will be treated as a separate unit of accounting and arrangement consideration will be allocated to that unit of accounting based on its selling price, which will be determined based on vendor-specific objective evidence, if available, third party evidence if vendor-specific objective evidence is not available or estimated selling price if neither vendor-specific nor third party evidence is available. For such separate units of accounting, the allocated arrangement consideration will be recognized as services are performed or products have been delivered, when the fee is fixed or becomes determinable and when collection is reasonably assured.

 

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For product sales under a distribution and commercialization agreement, we recognize revenue from the supply of product to the other party when all four revenue recognition criteria have been met (i.e., persuasive evidence of an arrangement exists, the product has been delivered, the price is fixed or determinable and collection is reasonably assured) and when risk of loss and title passes to the customer.

 

Gross profit sharing or royalties payments based on reported gross profits or sales of products for which distribution and commercialization rights have been granted to another party will be recognized based on contract terms when reported gross profits or sales are reliably measurable and collectibility is reasonably assured.

 

Stock-Based Compensation

 

Employee stock-based compensation cost is measured at the grant date, based on the fair value of the award, and is recognized as an expense over the employee’s requisite service period (generally the vesting period). Stock-based compensation expense is allocated among cost of goods sold, research and development and selling, general and administrative expenses, or included in the inventory carrying value and absorbed into inventory, based on the function of the related employee. Stock option awards granted to our nonemployee directors for their board-related services are included in employee stock-based compensation in accordance with current accounting standards. We use the Black-Scholes option-pricing model to estimate the fair value of our time-based vesting stock option awards and use the straight-line (single-option) method for expense attribution. We estimate forfeitures and recognize expense only for those shares expected to vest.

 

During the nine months ended September 30, 2014, we began to issue time-based vesting restricted stock units (RSUs), market-based vesting performance restricted stock units (PRSUs) and market-based vesting performance stock options (PSOs). There were no PRSU or PSO grants made during the three months ended June 30, 2014 and no RSU, PRSU or PSO grants made during the three months ended September 30, 2014.  RSU and PRSU grants cannot be transferred and, until they vest, the underlying shares are subject to forfeiture if the grantee’s service with us terminates prior to the release of the applicable vesting restrictions. The RSUs granted during the nine months ended September 30, 2014 will vest in equal tranches on the first four anniversaries of the applicable vesting commencement dates, subject to the grantee’s continued service with us. Upon vesting of RSUs, we will issue to the grantee thereof one share of common stock for each such RSU. The PSOs and PRSUs granted in the nine months ended September 30, 2014 will vest in full, subject to the grantee’s continued service with us, if at any time during the four-year period beginning March 21, 2014, the volume-weighted average price for our common stock exceeds $30 per share (using the VAP function on Bloomberg for the Company “ANAC US EQUITY VAP”, or successor thereof) for 30 consecutive trading days. If such vesting condition is not met within such four-year period, such PRSU and PSO grants will expire. Such RSUs, PSOs and PRSUs are subject to accelerated vesting in the event of certain terminations in connection with a change of control. We use a Monte Carlo valuation method to estimate the fair value of our market-based vesting PSO and PRSU grants. We will recognize the estimated expense of PSOs and PRSUs, as determined under the simulation models, over the expected life of the award, with no adjustment in future periods based upon our actual stock price over the performance period. Time-based vesting RSUs are valued at the closing price of our common stock on the date of grant.

 

We account for stock options issued to nonemployees based on their fair values on the measurement dates using the Black-Scholes option-pricing model. The fair values of the options granted to nonemployees are remeasured as they vest. As a result, the noncash charge to operations for nonemployee options that vest in any given reporting period is affected by changes in the fair value of our common stock during that period.

 

We recorded noncash stock-based compensation for employee and nonemployee stock option (including PSO) grants, employee RSU and PRSU grants and employee stock purchase program (ESPP) stock purchase rights of $3.7 million and $1.3 million for the three months ended September 30, 2014 and 2013, respectively and $11.6 million and $3.3 million for the nine months ended September 30, 2014 and 2013, respectively. Included in the amounts for the nine months ended September 30, 2014 was $3.0 million of stock-based compensation relating to the modification of options held by our former chief executive officer upon his resignation. As of September 30, 2014, we had outstanding

 

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options (including PSOs) to purchase 5,088,382 shares of our common stock and 447,000 RSUs and PRSUs outstanding and had $27.6 million of unrecognized stock-based compensation expense, net of estimated forfeitures, related to outstanding stock options and $0.2 million related to ESPP stock purchase rights that will be recognized over weighted-average periods of 3.0 years and 0.6 years, respectively. For the three and nine months ended September 30, 2014, there were 45,656 and 88,719 shares of our common stock purchased under the ESPP, respectively. We expect to continue to grant stock options, RSUs and ESPP stock purchase rights in the future, which may increase our stock-based compensation expense in future periods. If any of the assumptions used in the Black-Scholes option pricing model or Monte Carlo valuation method change significantly, stock-based compensation expense may differ materially in the future from that recorded in the current period.

 

Recent Accounting Pronouncements

 

In August 2014, the Financial Accounting Standards Board (FASB) issued an accounting standards update that set forth guidance relating to the evaluation of an entity’s ability to continue as a going concern. The guidance establishes management’s responsibility for evaluating whether there is substantial doubt about an entity’s ability to continue as a going concern in connection with preparing financial statements for each annual and interim reporting period. The guidance also requires certain disclosures about relevant conditions and events when there is substantial doubt about an entity’s ability to continue as a going concern. This guidance is effective for annual and interim reporting periods ending after December 15, 2016, with early adoption permitted. We will evaluate the guidance under this update and present the required disclosures on our financial statements at the time of adoption.

 

In June 2014, the FASB issued a new accounting standard on accounting for share-based payments for performance-based stock awards, which will require that a performance target that affects vesting and that could be achieved after the required service period be treated as a performance condition. We do not currently have any performance-based stock awards that meet these conditions. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2015. We are currently evaluating the effect that the updated standard will have on our consolidated financial statements.

 

In May 2014, the FASB issued a new accounting standard on revenue from contracts with customers, which will require us to recognize revenue when we transfer promised goods or services to a customer in an amount that reflects the consideration to which we expect to be entitled in exchange for those goods or services. The updated standard will replace most existing revenue recognition guidance under U.S. GAAP when it becomes effective and will permit the use of either the retrospective or cumulative effect transition method. Early adoption is not permitted. The standard also requires additional disclosure about the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including significant judgments and changes in judgments and assets recognized from costs incurred to obtain or fulfill a contract. The updated standard becomes effective for fiscal years, and interim periods within those years, beginning after December 15, 2016. We have not yet selected a transition method and are currently evaluating the effect that the updated standard will have on our consolidated financial statements and related disclosures.

 

In July 2013, a new accounting standard was issued that requires the netting of unrecognized tax benefits against a deferred tax asset for a net operating loss carryforward or other carryforward that would apply in the settlement of uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same-jurisdiction net operating loss or other tax carryforwards that would be utilized, rather than only against carryforwards that are created by the unrecognized tax benefits. The new standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. We adopted this guidance as of January 1, 2014, and its adoption did not have an effect on our financial statements.

 

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Results of Operations

 

Comparison of Three and Nine Months Ended September 30, 2014 and 2013

 

 

 

Three Months Ended September 30,

 

Nine Months Ended September 30,

 

 

 

2014

 

2013

 

Increase/
(decrease)

 

2014

 

2013

 

Increase/
(decrease)

 

 

 

(in thousands)

 

Research contracts revenue

 

$

2,889

 

$

3,611

 

$

(722

)

$

9,978

 

$

8,743

 

$

1,235

 

Distribution and commercialization agreement revenue

 

1,066

 

 

1,066

 

1,066

 

 

1,066

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of goods sold (1)

 

202

 

 

202

 

202

 

 

202

 

Research and development expenses(1)

 

19,521

 

12,460

 

7,061

 

54,717

 

33,765

 

20,952

 

Selling, general and administrative expenses(1)

 

7,707

 

6,809

 

898

 

23,130

 

16,611

 

6,519

 

Trademark agreement expense

 

6,800

 

 

6,800

 

6,800

 

 

6,800

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Interest income

 

66

 

15

 

51

 

189

 

43

 

146

 

Interest expense

 

1,089

 

1,135

 

(46

)

3,278

 

2,949

 

329

 

Loss on early extinguishment of debt

 

 

 

 

 

1,381

 

(1,381

)

Other expense

 

44

 

31

 

13

 

128

 

63

 

65

 

 


(1)                     Includes the following stock-based compensation expenses:

 

Cost of goods sold

 

$

9

 

$

 

$

9

 

$

9

 

$

 

$

9

 

Research and development expenses

 

1,519

 

744

 

775

 

3,853

 

1,910

 

1,943

 

Selling, general and administrative expenses

 

2,149

 

545

 

1,604

 

7,742

 

1,393

 

6,349

 

 

Comparison of Three Months Ended September 30, 2014 and 2013

 

Research contracts revenue. For the three months ended September 30, 2014, we recognized $1.8 million for research services performed under the Gates Foundation agreement, $0.6 million under our research contract with DTRA, $0.1 million for research funding under our collaboration with GSK and $0.4 million for research performed under our other agreements with not-for-profit organizations for neglected diseases. For the three months ended September 30, 2013, we recognized $1.7 million for research services performed under the Gates Foundation agreement, $0.1 million of which related to reimbursements for services performed prior to the effective date of the agreement. We also recognized $0.8 million for research funding and $0.2 million of the $3.5 million upfront fee received under the Lilly agreement, $0.4 million primarily for research funding under our collaboration with GSK and $0.5 million for research work performed under our other agreements with not-for-profit organizations for neglected diseases.

 

Distribution and commercialization agreement revenue.  For the three months ended September 30, 2014, we recognized $0.7 million of the $40.0 million in total upfront payments received from Sandoz under the Sandoz Agreement and $0.4 million from product sales of KERYDIN to Sandoz. We entered into the Sandoz Agreement in July 2014 and in September 2014, KERYDIN was launched in the United States by Sandoz pursuant to the Sandoz Agreement.

 

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Cost of goods sold. Cost of goods sold reflects costs capitalized into inventory for KERYDIN finished drug product that was picked up by Sandoz during the three months ended September 30, 2014 and for which the related product sales revenues from Sandoz are included in distribution and  commercialization agreement revenue for the same period. Costs recorded in connection with the manufacture of KERYDIN prior to us starting to capitalize such costs were recorded as research and development expenses. As a result, the cost of goods sold that we record for such product will be lower than the amount actually incurred to manufacture that product.

 

Research and development expenses. Research and development expenses consist primarily of costs associated with research activities, as well as costs associated with our product development efforts, including preclinical studies and clinical trials. Research and development expenses, including those paid to third parties, are recognized as incurred. Research and development expenses include:

 

·                  external research and development expenses incurred pursuant to agreements with third party manufacturing organizations, contract research organizations and investigational sites;

 

·                  employee and consultant-related expenses, which include salaries, benefits, stock-based compensation and consulting fees;

 

·                  third party supplier expenses; and

 

·                  facilities, depreciation and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, amortization or depreciation of leasehold improvements and equipment, laboratory supplies and other expenses.

 

For the three months ended September 30, 2014, research and development expenses increased by $7.1 million as compared to the same period in the prior year. In the third quarter of 2014, expenses for our AN2728 program increased by $7.1 million over the comparable quarter in 2013. The increase in AN2728 costs was primarily due to increased clinical trial and drug development activities, including the associated increase in internal efforts. In the third quarter of 2014, we were actively enrolling patients in two Phase 3 trials and a long-term safety trial for AN2728, as compared to the third quarter of 2013 when we were conducting less costly Phase 1 maximal use systemic exposure (MUSE) and cardiac safety trials for AN2728. In the third quarter of 2014, we were also manufacturing drug supplies for certain AN2728 regulatory activities and for our Phase 3 and long-term safety trials, as compared with a lower level of clinical and regulatory-related drug supply activities in the same period of the prior year. Research and development costs for our KERYDIN program decreased by $0.5 million in the third quarter of 2014 as compared to the same period in the prior year as declines in development and manufacturing costs offset an increase in clinical trials costs.  We obtained FDA approval of KERYDIN in July 2014 and began to capitalize ongoing KERYDIN manufacturing costs and associated compensation and facilities costs into inventory during that month. The decrease in KERYDIN costs was primarily due to a decrease in development and manufacturing activities related to our pre-commercialization and regulatory efforts and other pre-launch related activities. The increase in clinical trial costs for KERYDIN compared with the prior year quarter was due to our initiation in 2014 of a clinical study of KERYDIN to evaluate its efficacy, safety and local tolerability when treating mild-to-moderate toenail onychomycosis in conjunction with debridement, as needed. The cost increases from initiation of this study were partially offset by a decrease in the costs associated with our Phase 3 trials of KERYDIN, which were completed in 2013. In connection with our entry into the Sandoz Agreement, we and Sandoz reviewed development plans for KERYDIN and made a commercial decision to terminate the KERYDIN debridement study. Given the early stage of the study at the time of termination, we believe that we will realize cost savings from the termination. The termination was not the result of any safety concerns or input or guidance from the FDA.

 

In the third quarter of 2014, our research and development expenses for our DTRA and Gates Foundation programs increased by $0.6 million and $0.3 million, respectively, over the same period in 2013. We entered into the Gates Foundation agreement in the second quarter of 2013 and the DTRA agreement in the fourth quarter of 2013. We also had an increase of $0.8 million in our spending on other research activities. These increases were partially offset by a decrease of $0.7 million in research expenses under our collaboration with Lilly due to the early termination of the research term and a decrease in spending on our GSK and neglected disease programs of $0.4 million and $0.1 million, respectively.

 

Selling, general and administrative expenses. The increase in selling, general and administrative expenses of $0.9 million for the three months ended September 30, 2014 compared to the same period in 2013 was primarily due to increases of $1.6 million in stock-based compensation, $0.8 million in salaries, benefits and other compensation, $0.9 million in sales, marketing and compliance expenses for KERYDIN and $0.6 million of other costs. These increases were partially offset by a reduction of $3.0 million in legal fees compared to the third quarter of 2013, when we were actively engaged in arbitration and litigation proceedings related to our disputes with Valeant and Medicis that were settled in October 2013.

 

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Trademark agreement.  In September 2014, we entered into a coexistence and release agreement (the Trademark Agreement) relating to our KERYDIN trademark.  Pursuant to the Trademark Agreement, the parties thereto, among other things, acknowledged, on a worldwide basis, the respective rights of each party to certain trademarks, including KERYDIN in our case.  In connection with the Trademark Agreement, we paid $6.8 million to an unaffiliated third party and such third party granted us, Sandoz and, among others, our and Sandoz’s respective representatives, manufacturers, distributors, suppliers, licensees, marketing partners and customers a full release from any claims by such third party relating to the use of the KERYDIN trademark.

 

Interest income. The increase in interest income for the third quarter of 2014 compared to the same period in 2013 was primarily due to higher average investment balances resulting from our settlement with Valeant.

 

Interest expense and early extinguishment of debt. Interest expense increased in the three months ended September 30, 2014 compared to the same period in 2013 due to a higher effective interest rate that resulted from additional lender and legal fees we paid in connection with the December 2013 amendment to the Loan Agreement. Upon the early extinguishment of our debt under our then-existing loan facility in June 2013, we incurred a loss of $1.4 million, which consisted of the unaccrued balance of the final payment, the unamortized balances of the debt discount and deferred issuance costs and a prepayment penalty.

 

Other expense. Other expense increased in the third quarter of 2014 compared to the third quarter of 2013 due to higher amortization of deferred financing fees, which resulted mainly from additional debt issuance fees we paid in connection with the second and third tranches becoming available under the Loan Agreement.

 

Comparison of Nine Months Ended September 30, 2014 and 2013

 

Research contract revenue. For the nine months ended September 30, 2014, we recognized $5.0 million for research services performed under the Gates Foundation agreement, $0.2 million of which related to reimbursements for services performed prior to the effective date of the agreement. We also recognized $2.4 million under our research contract with DTRA, $0.8 million for research funding and $0.5 million of the upfront fee under our collaboration with Lilly, $0.2 million for research funding under our collaboration agreement with GSK and $1.1 million for research performed under our other agreements with not-for-profit organizations for neglected diseases. For the nine months ended September 30, 2013, we recognized $3.0 million for research services performed under our research agreement with the Gates Foundation, $0.1 million of which related to reimbursements for services performed prior to the effective date of the agreement, $2.4 million for research funding and $0.7 million of the upfront fee received under the Lilly agreement and $1.0 million primarily for research funding under our collaboration agreement with GSK. We also recognized $1.6 million for research work performed under other research and development agreements with not-for-profit organizations for neglected diseases.

 

Distribution and commercialization agreement revenue. For the nine months ended September 30, 2014, we recognized $0.7 million of the $40.0 million in total upfront payments received from Sandoz under the Sandoz Agreement and $0.4 million from product sales of KERYDIN to Sandoz.  We entered into the Sandoz Agreement in July 2014 and in September 2014, KERYDIN was launched in the United States by Sandoz pursuant to the Sandoz Agreement.

 

Cost of goods sold. Cost of goods sold reflects costs capitalized into inventory for KERYDIN finished drug product that was picked up by Sandoz during the nine months ended September 30, 2014 and for which the related product sales revenues from Sandoz are included in distribution and commercialization agreement revenue for the same period. Costs recorded in connection with the manufacture of KERYDIN prior to us starting to capitalize such costs were recorded as research and development expenses. As a result, the cost of goods sold that we record for such product will be lower than the amount actually incurred to manufacture that product.

 

Research and development expenses. For the nine months ended September 30, 2014, research and development expenses increased by $21.0 million as compared with the same period in the prior year, primarily due to increases in costs for our AN2728 program of $19.1 million. The increase in AN2728 costs in the first nine months of 2014 as compared with the same period in the prior year was primarily due to increased clinical trial and drug development activities, including the associated increase in internal efforts. In the first nine months of 2014, we incurred costs associated with actively enrolling patients in two Phase 3 trials and a long-term safety trial for AN2728, as compared with lower costs in same period of the prior year for our AN2728 Phase 2 dose ranging, Phase 1 MUSE and cardiac safety trials. In addition, we were manufacturing AN2728 drug supplies for certain regulatory activities and for our Phase 3 and long-term safety trials in the first nine months of 2014, as compared with a lower level of clinical- and regulatory-related AN2728 drug supply activities in the same period of the prior year. Our costs for our KERYDIN program decreased by $0.4 million in the first nine months of 2014 as compared with the nine months ended September 30, 2013 due to a decrease in our internal efforts, consulting and clinical trial expenses, partially offset by an increase in pre-commercialization and other pre-launch related costs.

 

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We obtained FDA approval of KERYDIN in July 2014 and began to capitalize ongoing KERYDIN manufacturing costs and associated compensation and facilities costs into inventory during that month.  Costs for our Gates Foundation and DTRA programs increased by $1.6 million and $2.2 million, respectively, during the first nine months of 2014 over the comparable period in 2013. The Gates Foundation contract was executed in April 2013 and the DTRA contract was executed in October 2013. We also had an increase of $2.5 million in the costs for our early stage research and AN3365 research activities.  Partially offsetting these increases were decreases of $2.5 million in research expenses under our collaboration with Lilly due to the early termination of the research term, $0.8 million in spending on our GSK TB program and $0.7 million in the costs for our neglected disease programs.

 

Selling, general and administrative expenses.  The increase in selling, general and administrative expenses of $6.5 million for the nine months ended September 30, 2014 compared to the same period in 2013 was primarily due to increases of $3.7 million in stock-based compensation and severance benefits related to the resignation of our former chief executive officer, $3.7 million in sales, marketing and compliance activities for KERYDIN, $3.3 million in other stock-based compensation and $3.1 million of other expenses including salaries, benefits, consulting and other outside services. These increases were partially offset by a reduction of $7.3 million in legal fees for the nine months ended September 30, 2014 as compared to the same period in the prior year, primarily due to the completion of our legal proceedings with Valeant and Medicis in late 2013.

 

Trademark agreement.  In September 2014, we entered into the Trademark Agreement, pursuant to which the parties thereto, among other things, acknowledged, on a worldwide basis, the respective rights of each party to certain trademarks, including KERYDIN in our case.  In connection with the Trademark Agreement, we paid $6.8 million to an unaffiliated third party and such third party granted us, Sandoz and, among others, our and Sandoz’s respective representatives, manufacturers, distributors, suppliers, licensees, marketing partners and customers a full release from any claims by such third party relating to the use of the KERYDIN trademark.

 

Interest income. The increase in interest income for the nine months ended September 30, 2014 compared to the same period in 2013 was primarily due to higher average investment balances resulting from our settlement with Valeant.

 

Interest expense and early extinguishment of debt. Interest expense increased in the nine months ended September 30, 2014 compared to the same period in 2013 due to the higher average outstanding balance of our debt and higher effective interest rate that resulted from our entry into the Loan Agreement with Hercules in June 2013 and the December 2013 amendment thereto. Upon the early extinguishment of our debt under our then-existing loan facility in June 2013, we incurred a loss of $1.4 million, which consisted of the unaccrued balance of the final payment, the unamortized balances of the debt discount and deferred issuance costs and a prepayment penalty.

 

Other expense. Other expense increased in the first nine months of 2014 compared to the first nine months of 2013 due to higher amortization of deferred financing fees related to the Loan Agreement.

 

Liquidity and Capital Resources

 

The following table sets forth the primary sources and uses of cash for each of the periods presented below (in thousands):

 

 

 

Nine months ended September 30,

 

 

 

2014

 

2013

 

Net cash used in operating activities

 

$

(23,749

)

$

(36,532

)

Net cash (used in) provided by investing activities

 

(81,438

)

1,733

 

Net cash provided by financing activities

 

7,290

 

30,539

 

Net decrease in cash and cash equivalents

 

$

(97,897

)

$

(4,260

)

 

Net cash used in operating activities was $23.7 million and $36.5 million for the nine months ended September 30, 2014 and 2013, respectively. The net cash used in operating activities for the first nine months of 2014 reflected our net loss adjusted for noncash items plus the net changes in operating assets and liabilities during this period, including those associated with increases in inventory and clinical trial-related advance payments and accrued liabilities. Net cash from operating activities for this period was also positively impacted by the receipt of the $40.0 million in total upfront payments from Sandoz under the Sandoz Agreement. For the first nine months of 2013, the net cash used in operating activities reflected our net loss adjusted for noncash items, which was partially offset by the net changes in operating assets and liabilities for the same period, including increases in our accounts payable and accrued liabilities.

 

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Net cash used in investing activities was $81.4 million during the first nine months of 2014 as purchases of investments with the proceeds from our settlement with Valeant and purchases of property and equipment exceeded the maturities of investments during this period. Our investing activities during the first nine months of 2013 provided net cash of $1.7 million, primarily because maturities of investments in this period exceeded purchases of investments, property and equipment and our transfers to restricted investments. For the nine months ended September 30, 2013, we transferred $4.5 million related to the redeemable common stock proceeds and the research funding received from the Gates Foundation to restricted investments as a result of restrictions placed on the use of such funds pursuant to our Gates Foundation agreement.

 

Net cash provided by financing activities was $7.3 million for the first nine months of 2014 compared to net cash provided by financing activities of $30.5 million in the same period of 2013. The net cash provided by financing activities for the first nine months of 2014 primarily reflects proceeds from the exercises of stock options and employee stock plan purchases. The net cash provided by financing activities for the first nine months of 2013 reflects net proceeds of $21.3 million from the sale of our common stock in May 2013, net proceeds of $1.3 million from the sale of our common stock under our equity distribution agreement with Wedbush in the first quarter of 2013, net proceeds of $5.0 million from the issuance of shares of redeemable common stock to the Gates Foundation, the $30.0 million drawdown of the first tranche under our Loan Agreement with Hercules and $1.2 million in proceeds from the exercises of stock options and employee stock plan purchases, partially offset by $28.2 million paid in respect of regularly scheduled principal payments and remaining obligations under our then-existing loan facility and financing fees, debt issuance costs and loan fees associated with the Loan Agreement.

 

We believe that our existing capital resources, including the net proceeds remaining from our issuance of Convertible Notes in October 2014 after repayment of the Loan Agreement, together with the payments we expect to receive based on sales of KERYDIN under the Sandoz Agreement, will be sufficient to meet our anticipated operating requirements for at least the next twelve months. Our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results could vary materially.

 

Our future capital requirements are difficult to forecast and will depend on many factors, including:

 

·                  the successful commercialization of KERYDIN pursuant to the Sandoz Agreement;

 

·                  the initiation, progress, timing, costs and results of preclinical studies and clinical trials for our product candidates and potential product candidates, including our ongoing and/or planned trials for AN2728;

 

·                  the success of our efforts under our contracts with the Gates Foundation and DTRA and the attainment of contingent event-based payments and royalties, if any, under our agreements with GSK and Lilly;

 

·                  the number and characteristics of product candidates that we pursue;

 

·                  the terms and timing of any future collaboration, licensing or other arrangements that we may establish;

 

·                  the outcome, timing and cost of regulatory approvals;

 

·                  the cost of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights;

 

·                  the effect of competing technological and market developments;

 

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·                  the cost and timing of completion of commercial-scale outsourced manufacturing activities;

 

·                  the cost of establishing sales, marketing and distribution capabilities for any product candidates for which we may receive regulatory approval;

 

·                  the cost of implementing healthcare compliance policies and procedures; and

 

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

 

If, over the next several years, adequate funds are not available, we may be required to delay, reduce the scope of or eliminate some, or all, of the above-listed activities that we control.

 

We began business operations in March 2002. As of September 30, 2014, we had an accumulated deficit of $207.5 million. Historically, we funded our operations primarily through the sale of equity securities, debt arrangements, payments received under our collaborations and research agreements, government contracts and grants and contracts with not-for-profit organizations for neglected diseases and our settlement with Valeant. We expect to incur operating losses in future years as we continue to develop our drug candidates, including AN2728. We may require additional capital to fund research and development activities, including clinical trials for our development programs and preclinical activities for our product candidates. Although we believe that our existing capital resources (including the net proceeds remaining from our issuance of Convertible Notes in October 2014 after repayment of the Loan Agreement), together with the payments we expect to receive based on sales of KERYDIN pursuant to the Sandoz Agreement, will be adequate to fund our operations for at least the next twelve months, we may also seek to finance our future cash needs through public or private equity offerings, debt financings or licensing, collaboration or other similar arrangements, or a combination of these sources.

 

Contractual Obligations

 

Our contractual obligations as of September 30, 2014 consisted primarily of obligations under lease agreements and our notes payable obligations under the Loan Agreement. In October 2014, we issued and sold $90.5 million aggregate principal amount of Convertible Notes and used approximately $30.8 million of the net proceeds to repay in full our outstanding indebtedness under, and terminate, the Loan Agreement.  The Convertible Notes are general unsecured obligations of ours, bear interest at a fixed rate of 2.00% per year (payable semiannually in arrears on April 15 and October 15 of each year, beginning on April 15, 2015) and will mature on October 15, 2021, unless earlier purchased, redeemed or converted. Our other contractual obligations for 2014 and beyond have not changed materially from those included in our Annual Report on Form 10-K for the year ended December 31, 2013, filed with the Securities and Exchange Commission on March 17, 2014. The following table summarizes our material contractual obligations at September 30, 2014, after giving effect to the issuance of the Convertible Notes and the repayment of the Loan Agreement in October 2014, and the effect such obligations are expected to have on our liquidity and cash flow in future years.

 

 

 

Payments due by period (in thousands)

 

 

 

Total

 

Remainder of
2014

 

1 - 3 years

 

3 - 5 years

 

Thereafter

 

Contractual obligations:

 

 

 

 

 

 

 

 

 

 

 

Operating leases

 

$

6,135

 

$

460

 

$

3,539

 

$

2,136

 

$

 

Convertible Notes (1)

 

103,170

 

 

3,620

 

3,620

 

95,930

 

Total contractual obligations

 

$

109,305

 

$

460

 

$

7,159

 

$

5,756

 

$

95,930

 

 


(1)  Represents Convertible Notes due in October 2021(including future interest payments at a fixed rate of 2.00% per year).

 

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We enter into contracts in the normal course of business with clinical research organizations for clinical trials and clinical supply manufacturing and with vendors for sales and marketing services, preclinical research studies, research supplies and other services and products for operating purposes. These contracts generally provide for termination on notice, and therefore we believe that our non-cancelable obligations under these agreements are not material.

 

Off-Balance Sheet Arrangements

 

We currently have no off-balance sheet arrangements.

 

Interest Rate Risk

 

The primary objective of our investment activities is to preserve our capital for the purpose of funding operations while at the same time maximizing the income we receive from our investments without significantly increasing risk. To achieve these objectives, our investment policy allows us to maintain a portfolio of cash equivalents and short-term and long-term investments in a variety of high credit quality securities, including U.S. government instruments, commercial paper, money market funds and corporate debt securities. Our investment policy prohibits us from holding auction rate securities or derivative financial instruments. To the extent that the investment portfolios of companies whose commercial paper is included in our investment portfolio may be subject to interest rate risks, which could be negatively impacted by reduced liquidity in auction rate securities or derivative financial instruments they hold, we may also be subject to these risks. However, our investment portfolio as of September 30, 2014 is comprised of a money market fund, federal agency securities with minimum ratings of AAA or AA+, corporate bonds with minimum ratings of A2/A and commercial paper with minimum ratings of P1/A1. The remaining average maturity of the entire portfolio is 153 days. Due to the short-term nature of our investments, we believe that there is no material exposure to interest rate risk and we are not aware of any material exposure to market risk.

 

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

A discussion of our exposure to, and management of, market risk appears in Part I, Item 2 of this Quarterly Report on Form 10-Q under the heading “Interest Rate Risk.”

 

ITEM 4. CONTROLS AND PROCEDURES

 

Evaluation of disclosure controls and procedures

 

Based on the evaluation of our disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) of the Securities Exchange Act of 1934, as amended (the Exchange Act)) required by Rules 13a-15(b) or 15d-15(b) of the Exchange Act, our Chief Executive Officer and Chief Financial Officer have concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective.

 

Changes in internal control over financial reporting

 

To address changes in our business in conjunction with our entry into the Sandoz Agreement, we have implemented new processes related to inventory, cost of goods sold and product sales. Other than such modifications and enhancements to our internal control over financial reporting, there has been no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

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PART II. OTHER INFORMATION

 

ITEM 1. LEGAL PROCEEDINGS

 

We are not a party to any material legal proceedings at this time. From time to time, we may be involved in litigation relating to claims arising in the ordinary course of our business.

 

ITEM 1A.              RISK FACTORS

 

Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors, as well as the other information in this Quarterly Report on Form 10-Q, before deciding whether to invest in shares of our common stock. The occurrence of any of the adverse developments described in the following risk factors could materially harm our business, financial condition, results of operations or prospects. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.

 

Risks Relating to Our Financial Position and Need for Additional Capital

 

Our ability to curtail our losses and reach profitability is unproven, and we may never achieve or sustain profitability.

 

We have recorded a net loss of $77.0 million for the nine months ended September 30, 2014 and do not expect to be profitable in 2014. With the exception of 2013, which was impacted by a significant legal settlement with Valeant Pharmaceuticals International, Inc. (Valeant), we have incurred net losses in each year since our inception, including net losses of approximately $56.1 million and $47.9 million for 2012 and 2011, respectively. As of September 30, 2014, we had an accumulated deficit of approximately $207.5 million. Historically, we have devoted most of our financial resources to research and development, including our preclinical development activities and clinical trials. We do not expect to receive revenues relating to sales of KERYDIN under the Sandoz Agreement over the remainder of 2014 sufficient to offset our losses for the year, and cannot guarantee that payments under the Sandoz Agreement will be sufficient to offset losses in future years. While Sandoz is responsible for selling, marketing, distribution, general and administrative costs and costs related to the commercialization of KERYDIN under the Sandoz Agreement, we expect that, as a general matter, both sales and marketing and research and development expenses for our product candidates will increase in the future as we progress such product candidates through clinical development into the commercialization stage, conduct our research and development activities under our various current and potential collaborations, including those related to our neglected diseases initiatives, advance our discovery research projects into the preclinical stage and continue our early-stage research. As a result of the foregoing, and as stated above, we expect to continue to experience net losses and negative cash flows in 2014. These losses and negative cash flows have had, and until we are profitable, will continue to have, an adverse effect on our stockholders’ equity and working capital.

 

Because of the numerous risks and uncertainties associated with pharmaceutical product development, we are unable to accurately predict the timing or amount of our expenses or when, or if, we will be able to maintain profitability. In addition, our expenses could increase if we are required by the United States Food and Drug Administration (FDA) to perform studies in addition to, or that are larger than, those that we currently expect. Whether we continue to incur future net losses will depend, in part, on our future expenses and our ability to generate revenues. Revenues from the Sandoz Agreement will depend in large part on the successful commercialization of KERYDIN. Prior to our entry into the Sandoz Agreement, we financed our operations primarily through the sale of equity securities, debt arrangements, government contracts and grants and payments under our agreements with GlaxoSmithKline LLC (GSK), Eli Lilly and Company (Lilly), the Bill and Melinda Gates Foundation (the Gates Foundation) and the United States Department of Defense, Defense Threat Reduction Agency (DTRA) and our arbitration settlement with Valeant. Revenues from our collaborations and research agreements with GSK, Lilly, the Gates Foundation and DTRA are uncertain because milestones or other contingent payments under our agreements with them may not be achieved or received. In addition, we may not be able to enter into other collaborations that will generate significant cash. If we are unable to successfully develop our product candidates, or if revenues from any product candidate that receives marketing approval, including KERYDIN, are insufficient, we will not achieve profitability. Even if we do achieve profitability, we may not be able to sustain or increase profitability.

 

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We have a limited operating history and we expect a number of factors to cause our operating results to fluctuate on a quarterly and annual basis, which may make it difficult to predict our future performance.

 

Our operations to date have been primarily limited to developing our technology and undertaking preclinical studies and clinical trials of our product candidates and we are reliant on collaborators for certain of our products. In particular, under the Sandoz Agreement, Sandoz is responsible for the distribution and commercialization of KERYDIN in the United States. Consequently, any predictions regarding our future success or viability may not be as accurate as they could be if we had a longer operating history. Our financial condition and operating results have varied significantly in the past and will continue to fluctuate from quarter-to-quarter or year-to-year due to a variety of factors, many of which are beyond our control. Factors relating to our business that may contribute to these fluctuations include the following risk factors, as well as other factors described elsewhere in this Quarterly Report on Form 10-Q:

 

·                  the successful commercialization of KERYDIN pursuant to the Sandoz Agreement;

 

·                  our ability to timely obtain and maintain regulatory approval for AN2728 or any of our other product candidates;

 

·                  competition from existing products or new products that may emerge, including Jublia, Valeant’s efinaconazole product that was approved by the FDA for the treatment for onychomycosis of the toenails in the United States in June 2014;

 

·                  our dependency on third party manufacturers to supply or manufacture our products;

 

·                  our ability to establish an effective sales, marketing and distribution infrastructure in a timely manner;

 

·                  market acceptance of KERYDIN or our product candidates;

 

·                  delays in the commencement, enrollment and timing of clinical testing for our product candidates, including our Phase 3 trials of AN2728 for the treatment of mild-to-moderate atopic dermatitis;

 

·                  the success of our clinical trials through all phases of clinical development;

 

·                  any delays in regulatory review and approval of product candidates in clinical development;

 

·                  potential side effects of our product candidates that could delay or prevent commercialization or cause an approved drug to be taken off the market;

 

·                  the ability of patients or healthcare providers to obtain coverage of or sufficient reimbursement for our products;

 

·                 our ability to obtain additional funding to develop our product candidates;

 

·                  our ability to receive approval for and commercialize KERYDIN or our product candidates outside of the United States;

 

·                  our ability to establish or maintain collaboration, licensing or other arrangements;

 

·                  our ability and the ability of third parties to protect and defend intellectual property rights;

 

·                  costs related to and outcomes from potential litigation;

 

·                  our ability to adequately support future growth;

 

·                  our ability to attract and retain key personnel to manage our business effectively;

 

·                  our ability to maintain our accounting systems and controls;

 

·                  potential product liability claims;

 

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·                  potential liabilities associated with hazardous materials; and

 

·                  our ability to maintain adequate insurance coverage.

 

Due to the various factors mentioned above, and others, the results of any quarterly or annual periods should not be relied upon as indications of future operating performance.

 

We may continue to require substantial additional capital and if we are unable to raise capital when needed, we would be forced to delay, reduce or eliminate our product development programs.

 

The development and commercialization of pharmaceutical products is expensive. The costs include those associated with conducting preclinical and clinical trials, interactions with regulatory authorities and the expenses associated with product commercialization. If, for example, the FDA requires that we perform additional studies beyond those that we currently expect, our expenses could increase materially beyond what we currently anticipate and the timing of any potential product approval may be delayed.  Although we believe that our existing capital resources (including the net proceeds from our issuance of Convertible Notes in October 2014 remaining after repayment of the Loan Agreement), together with the payments we expect to receive based on sales of KERYDIN pursuant to the Sandoz Agreement, will be sufficient to meet our anticipated operating requirements for at least the next twelve months, we may need to raise additional capital to fund our research and development activities, including clinical trials for our development programs and preclinical activities for our product candidates, and meet our operating requirements beyond the next twelve months. Furthermore, any delays in, or unanticipated costs associated with, our development, regulatory and commercial efforts could significantly increase the amount of additional capital required for us to conduct these research, development and commercialization activities and meet our operating requirements beyond the next twelve months. Our forecast of the period of time through which our financial resources will be adequate to support our operations is a forward-looking statement that involves risks and uncertainties, and actual results, including the costs to maintain our currently planned operations, could vary materially.

 

Unless and until we can generate a sufficient amount of revenue from our products, including sales of KERYDIN under the Sandoz Agreement, we expect to finance future cash needs through public or private equity offerings, debt financings or licensing, collaboration or other similar arrangements, or a combination of these sources. Additional funds may not be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate some of our research or development programs or our commercialization efforts and may not be able to make scheduled debt payments on a timely basis or at all. To the extent that we raise additional funds by issuing equity securities or securities convertible into or exchangeable for our common stock (such as the Convertible Notes), our stockholders may experience additional dilution, and debt financing, if available, may involve restrictive covenants and the granting of security interests over our assets. To the extent that we raise additional funds through collaborations and licensing arrangements, it may be necessary to relinquish some rights to our technologies or our products or product candidates or grant licenses on terms that may not be favorable to us. We may seek to access the public or private capital markets whenever conditions are favorable, even if we do not have an immediate need for additional capital at that time.

 

Our forecasts regarding the period of time that our existing capital resources will be sufficient to meet our operating requirements, the timing of our future capital resource requirements, both near and long-term, will depend on many factors, including, but not limited to:

 

·                  the successful commercialization of KERYDIN pursuant to the Sandoz Agreement;

 

·                  the outcome, timing and cost of regulatory approvals;

 

·                  the effects of competing technological and market developments, including Jublia, Valeant’s efinaconazole product that was approved by the FDA for the treatment for onychomycosis of the toenails in the United States in June 2014;

 

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·                  the cost and timing of completion of commercial-scale outsourced manufacturing activities;

 

·                  the cost of establishing sales, marketing and distribution capabilities for product candidates for which we may receive regulatory approval;

 

·                  the initiation, progress, timing, costs and results of preclinical studies and clinical trials for our product candidates and potential product candidates, including the Phase 3 clinical trials of AN2728;

 

·                  the success of our collaborations and research agreements and the attainment of milestones and royalty payments, if any, under those agreements;

 

·                  the number and characteristics of product candidates that we pursue;

 

·                  the terms and timing of any future collaboration, licensing or other arrangements that we may establish;

 

·                  the cost of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and

 

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

 

We may not have sufficient cash flow from our business to pay our indebtedness.  In addition, we could incur additional indebtedness that could have adverse effects on our business.

 

After giving effect to the issuance of the Convertible Notes and the repayment of the Loan Agreement in October 2014, we had total indebtedness of $90.5 million.  Our ability to pay interest on, to repay or to refinance our indebtedness, or to make cash payments in connection with any conversion of the Convertible Notes, depends on our future performance, which is subject to economic, financial, competitive and other factors beyond our control. Our business may not generate cash flow from operations in the future sufficient to service our indebtedness, fund our research and development activities and make necessary capital expenditures. If we are unable to generate such cash flow, we may be required to adopt one or more alternatives, such as selling assets, refinancing indebtedness, restructuring indebtedness or obtaining additional equity capital on terms that may be onerous or highly dilutive. We may not be able to engage in any of these activities or to engage in these activities on desirable terms, which could result in a default on our debt obligations.

 

In the future, we may incur additional indebtedness in connection with financing acquisitions, strategic transactions or for other purposes. Any increase in our indebtedness increases the risk that we may be unable to generate enough cash to satisfy our debt obligations and could have other important consequences to our business. For example, it could:

 

·                  increase our vulnerability to general adverse economic and industry conditions;

 

·                  require us to dedicate a substantial portion of our cash flow from operations to payments on our indebtedness, thereby reducing the availability of our cash flow to fund working capital and other general corporate purposes;

 

·                  limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

 

·                  restrict us from exploiting business opportunities;

 

·                  place us at a competitive disadvantage compared to our competitors that have less indebtedness or greater cash flow; and

 

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·                  limit our ability to borrow additional funds for working capital, product development programs, capital expenditures, acquisitions, debt service requirements, execution of our business strategy or other general corporate purposes.

 

In addition, the agreements that may govern any future indebtedness that we may incur may contain financial and other restrictive covenants that will limit our ability to engage in activities that may be in our long-term best interests and may require the granting of security interests over our assets. Our failure to comply with those covenants could result in an event of default that, if not cured or waived, could result in the acceleration of all of our debt, potential foreclosure on our assets and other adverse results.

 

Risks Relating to the Development, Regulatory Approval and Commercialization of Our Products and Product Candidates

 

If KERYDIN fails to timely achieve and sustain commercial success, our business will suffer, our future prospects may be harmed and our stock price would likely decline.

 

KERYDIN is our first product to be approved by the FDA and is our first commercialized product. Unless and until we successfully commercialize another product candidate or obtain approval to market KERYDIN, directly or through another collaboration, in jurisdictions outside of the United States, the payments that we receive under the Sandoz Agreement will constitute the entirety of our revenues from product sales. The amount of such payments will depend largely on the commercial success of KERYDIN, which will determine the level of gross profit sharing payments, if any, in excess of any minimum amounts that we are entitled to under the Sandoz Agreement. In addition, Sandoz is responsible for the distribution and commercialization of KERYDIN in the United States and controls sales, marketing and other commercialization matters under the Sandoz Agreement, including pricing and reimbursement matters. We have limited ability to control such decisions, which may affect the commercial success of KERYDIN. The commercial success of KERYDIN will depend on, and may be limited by, a number of factors, including the following:

 

·                  acceptance of and ongoing satisfaction with KERYDIN by the medical community, patients receiving treatment and third party payers in the United States, and eventually in foreign markets to the extent we seek and receive marketing approvals abroad;

 

·                  KERYDIN’s market share;

 

·                  the extent and effectiveness of the development, sales and marketing and distribution support KERYDIN receives from Sandoz;

 

·                  the amount of resources and efforts utilized by Sandoz in relation to the commercialization of KERYDIN;

 

·                  the existence of competing products, including whether Jublia, Valeant’s efinaconazole product that was approved by the FDA for the treatment for onychomycosis of the toenails in the United States in June 2014, or other competing products or therapies, are prescribed instead of KERYDIN for certain patients or are perceived as superior to, or more cost-effective than, KERYDIN by physicians or patients;

 

·                  adequate coverage or reimbursement for KERYDIN by government healthcare programs and third party payers, including private health coverage insurers and health maintenance organizations; and

 

·                  the ability of patients to afford any required co-payments for KERYDIN.

 

As discussed above, we have limited ability under the Sandoz Agreement to control decisions that may affect the commercial success of KERYDIN. If Sandoz is unable to successfully commercialize KERYDIN, our revenues would be impacted and our business would be seriously harmed.

 

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We cannot be certain that AN2728 or any of our other wholly-owned or partnered product candidates will receive regulatory approval, and without regulatory approval our product candidates will not be able to be marketed.

 

We have invested a significant portion of our efforts and financial resources in the development of our most advanced product candidates. Our ability to generate significant revenue related to product sales will depend on the successful development and regulatory approval of our product candidates.

 

Currently, our lead product candidate is AN2728, an investigational anti-inflammatory PDE-4 inhibitor in development for the potential treatment of mild-to-moderate atopic dermatitis. We initiated Phase 3 studies of AN2728 for the treatment of mild-to-moderate atopic dermatitis in the first quarter of 2014. We may conduct lengthy and expensive Phase 3 clinical trials of AN2728 only to learn that this drug candidate is not a safe or effective treatment, in which case these clinical trials may not lead to regulatory approval. Similarly, GSK’s development of our partnered product candidate in tuberculosis (TB) and Lilly’s development program for our partnered animal health product candidate may be subject to delays in development and not lead to regulatory approval from the FDA and similar foreign regulatory agencies. Such failure to timely develop and obtain regulatory approvals would prevent our product candidates from being marketed and would have a material and adverse effect on our business.

 

The development of a product candidate, including preclinical and clinical testing, manufacturing, quality systems, labeling, approval, record-keeping, selling, promotion, marketing and distribution of products, is subject to extensive regulation by the FDA in the United States and regulatory authorities in other countries, with regulations differing from country to country. We are not permitted to market our product candidates in the United States until we receive approval of an NDA from the FDA. Obtaining approval of an NDA is a lengthy, expensive and uncertain process. An NDA must include extensive preclinical and clinical data and supporting information to establish the product candidate’s safety and effectiveness for each indication. The approval application must also include significant information regarding the chemistry, manufacturing and controls for the product. The regulatory development and review process typically takes years to complete and approval is never guaranteed. If a product is approved, the FDA may limit the indications for which the product may be used, include extensive warnings on the product labeling or require costly ongoing requirements for post-marketing clinical studies and surveillance or other risk management measures to monitor the safety or efficacy of the product candidate. Markets outside of the United States also have requirements for approval of drug candidates with which we must comply prior to marketing. Obtaining regulatory approval for marketing of a product candidate in one country does not ensure we will be able to obtain regulatory approval in other countries but a failure or delay in obtaining regulatory approval in one country may have a negative effect on the regulatory process in other countries. Any regulatory approval of any of our products or product candidates, once obtained, may be withdrawn. If AN2728 or any of our other wholly-owned or partnered product candidates do not receive regulatory approval, we may not be able to generate sufficient revenue to become profitable or to continue our operations. Moreover, our submission of an NDA or our receipt of regulatory approval with respect to any product does not assure the commercial success of such product.

 

Delays in the commencement, enrollment and completion of clinical trials could