1. Business Organization and Basis of Presentation

Description of the Business

Sucampo Pharmaceuticals, Inc., (Company) is a global biopharmaceutical company focused on developing, identifying, acquiring and bringing to market innovative medicines that meet unmet medical needs. The Company’s primary focus areas are medicines that treat gastrointestinal, ophthalmic, autoimmune, inflammatory, neurological and oncology disorders.

The Company currently generates revenue mainly from product royalties, development and milestone payments, product sales and reimbursements for development activities. The Company expects to continue to incur significant expenses for the next several years as it continues its research and development activities, seeks additional regulatory approvals and additional indications for approved products and other compounds, and seeks strategic opportunities for acquiring new products and product candidates.

AMITIZA^® (lubiprostone) is being marketed in the United States for three gastrointestinal indications under the collaboration and license agreement (as amended in October 2014, the North America Takeda Agreement) with Takeda Pharmaceutical Company Limited (Takeda). These indications are chronic idiopathic constipation (CIC) in adults, irritable bowel syndrome with constipation (IBS-C) in adult women and opioid-induced constipation (OIC) in adults suffering from chronic non-cancer related pain. Under the North America Takeda Agreement, the Company is primarily responsible for clinical development activities, while Takeda is responsible for commercialization of AMITIZA in the United States (U.S.) and Canada. The Company and Takeda initiated commercial sales of AMITIZA in the U.S. for the treatment of CIC in April 2006, for the treatment of IBS-C in May 2008 and for the treatment of OIC in May 2013. Takeda is currently required to provide a minimum annual commercial investment under the North America Takeda Agreement and may reduce the minimum annual commercial investment on a specified date, or earlier if a generic equivalent enters the market. In October 2015, Health Canada approved AMITIZA for CIC in adults. In October 2014, the Company and Takeda executed amendments to the North America Takeda Agreement which, among other things, extended the term of the North America Takeda Agreement beyond December 2020. During the extended term beginning in January 2021, Takeda and the Company will share the annual net sales revenue of the branded AMITIZA products.

The Company has also partnered with Par Pharmaceuticals, Inc. (Par) and Dr. Reddy’s Laboratories, Ltd. (Dr. Reddy’s) in connection with the settlement of patent litigation in the U.S. related to the Company’s AMITIZA 8 mcg and 24 mcg soft gelatin capsule products. Under the Company’s agreement with Par, the Company granted Par a non-exclusive license to market Par’s generic version of lubiprostone 8 mcg and 24 mcg soft gelatin capsules in the U.S. for the indications approved for AMITIZA beginning January 1, 2021, or earlier under certain circumstances. Beginning on January 1, 2021, Par will split with the Company the gross profits of the licensed products sold during the term of the agreement, which continues until each of the Company’s related patents has expired. Under the Company’s agreement with Dr. Reddy’s, the Company granted Dr. Reddy’s a non-exclusive license to market Dr. Reddy’s generic version of lubiprostone 8 mcg and 24 mcg soft gelatin capsules in the U.S. for the indications approved for AMITIZA. This license does not begin until more than six years from November 9, 2016, or earlier under certain circumstances. Dr. Reddy’s will pay to the Company a share of net profits of generic lubiprostone products sold during the term of the agreement, which decreases over time and ends when all of the Company’s related patents have expired. In the event that either Par or Dr. Reddy’s elect to launch an authorized generic form of lubiprostone, the Company has agreed to supply such product under the terms of a manufacturing and supply agreement at a negotiated price.

In Japan, AMITIZA is marketed under a license, commercialization and supply agreement (the Japan Mylan Agreement) that was transferred to Mylan, Inc. (Mylan) from Abbott Laboratories, Inc. (Abbott), as of February 2015, as part of Mylan’s acquisition of a product portfolio from Abbott. The Company received approval of its new drug application (NDA) for AMITIZA for the treatment of chronic constipation (CC), excluding constipation caused by organic diseases, from Japan’s Ministry of Health, Labour and Welfare in June 2012 and pricing approval in November 2012. AMITIZA is the only prescription medicine for CC approved in Japan. The Company did not experience any significant changes in the commercialization of AMITIZA in Japan as a result of the transfer of the Japan Mylan Agreement from Abbott to Mylan.

In May 2015, the Company entered into an exclusive license, development, commercialization and supply agreement (the China Gloria Agreement) with Harbin Gloria Pharmaceuticals Co., Ltd. (Gloria) for AMITIZA in the People’s Republic of China. Under the China Gloria Agreement, Gloria is responsible for all development activities and costs, as well as commercialization and regulatory activities, for AMITIZA in the People’s Republic of China. The Company will be the exclusive supplier of AMITIZA to Gloria at an agreed upon supply price. Upon entering into the China Gloria Agreement, the Company received an upfront payment of $1.0 million. In June 2015, the China Food and Drug Administration accepted an Investigational New Drug (IND) application for a pivotal trial of AMITIZA in patients with CIC; as a result, the Company received an additional payment of $500,000 from Gloria. In addition to the $1.5 million in payments received and recognized as revenue through June 2015, the Company is eligible to receive an additional payment in the amount of $1.5 million upon the occurrence of a specified regulatory or commercial milestone event.

In October 2014, the Company entered into an exclusive license, development, commercialization and supply agreement (the Global Takeda Agreement) for lubiprostone with Takeda, through which Takeda has the exclusive rights to further develop and commercialize AMITIZA in all global markets, except the U.S., Canada, Japan and the People’s Republic of China. Takeda became the marketing authorization holder in Switzerland in April 2015, as well as in the United Kingdom (U.K.), Austria, Belgium, Germany, Netherlands, Ireland, Italy, Luxembourg and Spain during 2016.

Before the execution of the Global Takeda Agreement, the Company retained full rights to develop and commercialize AMITIZA for the rest of the world’s markets outside of the U.S., Canada and Japan. In the U.K., the Company received approval in September 2012 from the Medicines and Healthcare Products Regulatory Agency (MHRA) for the use of AMITIZA to treat CIC. The Company made AMITIZA available in the U.K. in the fourth quarter of 2013. In July 2014, National Institute of Health and Care Excellence (NICE) published the technology appraisal guidance recommending the use of AMITIZA in the treatment of CIC and associated symptoms in adults who have failed laxatives. In January 2015, the Company successfully completed the European mutual recognition procedure (MRP) for AMITIZA for the treatment of CIC in select European countries, resulting in marketing authorizations in these countries.

In Switzerland, AMITIZA was approved to treat CIC in 2009. In 2012, the Company reached an agreement with the Bundesamt fur Gesundheit, (BAG), the Federal Office of Public Health in Switzerland, on a reimbursement price for AMITIZA in Switzerland, and began active marketing in the first quarter of 2013. In February 2014, the Company announced that the BAG revised several reimbursement limitations with which AMITIZA was first approved for reimbursement and inclusion in the Spezialitätenliste (SL) to allow all Swiss physicians to prescribe AMITIZA to patients who have failed previous treatments with at least two laxatives over a nine-month period. In July 2014, AMITIZA was approved for the treatment of OIC in chronic, non-cancer adult patients by the Swissmedic, the Swiss Agency for Therapeutic Products, and in October 2015, the BAG added this indication to the SL.

In October 2015, Takeda obtained approval of the clinical trial application (CTA) for AMITIZA for the treatment of CIC and IBS-C in Russia that was submitted in June 2015. In December 2015, a CTA was filed for AMITIZA for the treatment of CIC, IBS-C and OIC in Mexico and South Korea. Takeda initiated Phase 3 registration trials in Russia in March 2016 and in South Korea and Mexico in May 2016. An NDA for the treatment of CIC, IBS-C, and OIC was submitted in Israel in June 2015 and approved in July 2016. An NDA for the treatment of CIC, IBS-C and OIC was approved in Kazakhstan in December 2015. Additional NDA submissions have been made by Takeda in Singapore in May 2016, and in South Africa and Indonesia in June 2016, and are planned in various other markets in 2017 and future years.

In the U.S., the Company ceased marketing RESCULA (unoprostone isopropyl), an ophthalmology product, in the fourth quarter of 2014 and no product was made available after the March 2015 expiration date. In May 2015, the Company returned all licenses for unoprostone isopropyl to R-Tech Ueno, Ltd. (R-Tech). As part of the acquisition of R-Tech in October 2015, the Company acquired all rights to RESCULA. RESCULA is being commercialized by Santen Pharmaceutical Co., Ltd. in Japan, and Zuellig Pharma Inc. in Taiwan.

The Company’s clinical development programs include the following:

Lubiprostone Alternate Formulation

The Company is developing an alternate formulation of lubiprostone for both adult and pediatric patients. Takeda has agreed to fund 100% of the costs, up to a cap, of this alternate formulation work. The Company recently completed a Phase 3 study to evaluate the bioequivalence of the alternate “sprinkle” and capsule formulations of lubiprostone as compared to placebo in adult subjects with CIC. The results of the study did not show bioequivalence between the formulations, although clinical activity was observed and treatment was well tolerated. The Company’s focus continues to be on the potential approval of the pediatric indication; however, the Company has announced that it will not be moving forward with an NDA submission for the sprinkle formulation in adults.

Lubiprostone for Pediatric Functional Constipation

A Phase 3 program required to support an application for marketing authorization of lubiprostone for pediatric functional constipation comprises four clinical trials. The first two trials, one of which was completed in late 2016, test the soft gelatin capsule formulation of lubiprostone in patients 6 to 17 years of age. The first of these trials was a pivotal 12-week, randomized, placebo-controlled trial which was initiated in December 2013 and completed enrollment in April 2016. The second trial is a follow-on, long-term safety extension trial that was initiated in March 2014. In November 2016, the Company announced that the Phase 3 trial of AMITIZA in pediatric functional constipation in children 6 to 17 years of age failed to achieve its primary endpoint of overall spontaneous bowel movement (SBM), response. The trial achieved statistical significance for some secondary endpoints, notably overall SBM frequency, straining, and stool consistency. In addition, in this study lubiprostone was well tolerated. The Company has entered into a process with the U.S. Food and Drug Administration (FDA) and other constituencies and, as a result of initial discussion with the FDA, submitted a supplemental NDA on July 28, 2017, which has been accepted with priority review. Additionally, after further consultations with the FDA to better determine the doses and endpoints that should be studied, we expect the Phase 3 program for the alternate formulation of lubiprostone described above will be followed in mid-2018 with a Phase 3 program in patients 6 months to likely 6 years of age using the alternate formulation. Takeda agreed to fund 70% of the costs, up to a cap, and then 50% of the costs thereafter, of this pediatric functional constipation program. In June 2017, the Company reached the spending cap; accordingly, Takeda is now responsible for reimbursing 50% of the pediatric research and development costs.

CPP 1-X/Sulindac Combination Product

In January 2016, the Company entered into an option and collaboration agreement under which Cancer Prevention Pharmaceuticals, Inc. (CPP) granted the Company the sole option to acquire an exclusive license to commercialize CPP-1X/sulindac combination product in North America. This product is currently in a Phase 3 clinical trial, which is being conducted by CPP for the treatment of familial adenomatous polyposis (FAP). Under the agreement with CPP, the Company has the exclusive option to license this product in North America. There are currently no approved treatments for FAP.  The ongoing Phase 3 study, known as CPP FAP-310, is a 150-patient, three-arm, double-blind, randomized trial of the combination agent and the single agent comparators.  On June 7, 2017, CPP informed the Company that an Independent Data Monitoring Committee (IDMC), following a planned interim futility analysis, found no reason to discontinue the Phase 3 study, CPP FAP-310, evaluating CPP-1X/sulindac for adults with FAP. Results from the clinical trial are expected in 2018. Pursuant to the Company’s agreement with CPP, the Company made the $4.5 million payment for the second option fee tranche in July 2017, which was recorded in research and development expense for the nine months ended September 30, 2017. In September 2017, the Company made a further $5.0 million investment in CPP, in the form of a convertible note, pursuant to its license arrangement with CPP.

VTS-270 for Niemann-Pick Disease Type C1 (NPC-1)

On March 31, 2017, the Company entered into an Agreement and Plan of Merger with Vtesse Inc. (Vtesse), a privately-held rare disease company. The Company acquired Vtesse’s lead product candidate, known as VTS-270, upon closing the acquisition on April 3, 2017. VTS-270 is a well-characterized mixture of 2-hydroxypropyl-ß-cyclodextrins (HPßCD) with a specific compositional fingerprint that distinguishes it from other HPßCD mixtures. It is administered by an intrathecal infusion to directly address the neurological manifestations of disease. Preclinical and early clinical studies suggest that the administration of VTS-270 may slow or stop certain indicators of NPC-1, an ultra-orphan, progressive and fatal disease caused by a defect in lipid transport within the cell. VTS-270, which is currently in a fully-enrolled pivotal Phase 2b/3 trial, has been granted breakthrough therapy designation in the U.S. and orphan designation in both the U.S. and EU. Effective treatment of NPC-1 remains a high unmet need, with no approved products for patients in the U.S. Results from the pivotal trial are expected in mid-2018.

The Company accounted for the transaction as an asset acquisition and incurred an acquired in-process research and development charge of $186.6 million (and no related current tax benefit) in the second quarter of 2017. Additionally, the Company recorded a deferred tax asset of $13.6 million related to the acquired net operating loss.

Basis of Presentation

The accompanying unaudited Condensed Consolidated Financial Statements have been prepared in accordance with generally accepted accounting principles in the United States of America (GAAP) and the rules and regulations of the U.S. Securities and Exchange Commission (SEC) for interim financial information. Accordingly, they do not include all of the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the Company’s Consolidated Financial Statements as of and for the year ended December 31, 2016 included in the Company’s Annual Report on Form 10-K, which was filed with the SEC on March 8, 2017. The financial information as of September 30, 2017 and for the three and nine months ended September 30, 2017 and 2016 is unaudited. The year-end condensed balance sheet data was derived from audited financial statements, but does not include all disclosures required by GAAP. In the opinion of the Company’s management, all adjustments, consisting only of normal recurring adjustments or accruals, considered necessary for a fair statement of the results of these interim periods have been included. The results of the Company’s operations for any interim period are not necessarily indicative of the results that may be expected for any other interim period or for a full fiscal year.

The Condensed Consolidated Financial Statements include the accounts of the Company and its wholly-owned subsidiaries: Sucampo AG (SAG) and Sucampo Acquisitions GmbH (SAQ) based in Zug, Switzerland and Vtesse Europe Ltd., based in the United Kingdom, through which the Company conducts certain of its worldwide and European operations; Sucampo Pharma, LLC (SPL) based in Tokyo, Japan, through which the Company conducts its Asian operations, manufacturing and certain development operations; and Sucampo Pharma Americas LLC (SPA) and Vtesse Inc., based in Rockville, Maryland, through which the Company conducts its North American operations. All inter-company balances and transactions have been eliminated.

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

2. Summary of Significant Accounting Policies

Certain Risks, Concentrations and Uncertainties

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist of cash and cash equivalents, restricted cash and receivables. The Company places its cash, cash equivalents and restricted cash with highly rated financial institutions. As of September 30, 2017 and December 31, 2016, approximately $1.1 million, or 1.5%, and $1.2 million, or less than 1%, respectively, of the Company’s cash, cash equivalents, and restricted cash were issued or insured by the U.S. government or other government agencies. The Company has not experienced any losses on these accounts related to amounts in excess of insured limits.

Revenues from Takeda, an unrelated party, accounted for 63.0% and  65.7% of the Company’s total revenues for the three months ended September 30, 2017 and 2016, respectively, and 62.6% and 65.6% of the Company’s total revenues for the nine months ended September 30, 2017 and 2016, respectively. Accounts receivable and product royalties receivable from Takeda accounted for 69.0% and 69.6% of the Company’s total accounts receivable and product royalties receivable at September 30, 2017 and December 31, 2016, respectively.

Revenues from another unrelated party, Mylan, accounted for 33.5% and 30.1% of the Company’s total revenues for the three months ended September 30, 2017 and 2016, respectively, and 33.3% and 29.6% of the Company’s total revenues for the nine months ended September 30, 2017 and 2016, respectively. Accounts receivable from Mylan accounted for 27.1% and 30.1% of the Company’s total accounts receivable and product royalties receivable at September 30, 2017 and December 31, 2016, respectively.

The Company depends significantly upon collaborations with Takeda and Mylan, and its activities may be impacted if these relationships are disrupted.

Fair Value of Financial Instruments

The carrying values of the Company’s financial instruments approximate their fair values due to their short maturities, independent valuations or internal assessments. The Company’s financial instruments include cash and cash equivalents, restricted cash, receivables, accounts payable and other accrued liabilities. The Company’s investment in CPP is measured at fair value on a recurring basis, and the Company estimated the fair value of its long-term debt as of September 30, 2017 based on the available market data as of September 30, 2017.

Variable Interest Entities

The Company performs initial and on-going evaluations of the entities with which it has variable interests, such as equity ownership, in order to identify entities (i) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support or (ii) in which the equity investors lack an essential characteristic of a controlling financial interest. Such entities are classified as variable interest entities (VIEs). If an entity is identified as a VIE, the Company performs an assessment to determine whether the Company has both (i) the power to direct activities that most significantly impact the VIE’s economic performance and (ii) have the obligation to absorb losses from or the right to receive benefits of the VIE that could potentially be significant to the VIE. If both of these criteria are satisfied, the Company is identified as the primary beneficiary of the VIE. As of September 30, 2017 and December 31, 2016, CPP, in which the Company held a variable interest, was determined to be a VIE. However, as described in Note 8, the Company does not have the power to direct CPP’s economic performance and, as a result, the Company is not the primary beneficiary of CPP and the entity is not consolidated with the financial statements of the Company.

Recently Adopted Accounting Pronouncements

In July 2015, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) No. 2015-11, "Inventory (Topic 330): Simplifying the Measurement of Inventory." ASU No. 2015-11 applies only to inventory for which cost is determined by methods other than last in, first-out and the retail inventory method, which includes inventory that is measured using first-in, first-out or average cost. Inventory within the scope of this standard is required to be measured at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation. The Company adopted this standard on January 1, 2017. The adoption of this standard had no impact on the Company’s consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-09, “Improvements to Employee Share-Based Payment Accounting,” which changes the accounting for certain aspects of share-based payments to employees. The new guidance requires excess tax benefits and tax deficiencies to be recorded in the statement of operations when the awards vest or are settled. In addition, cash flows related to excess tax benefits will no longer be separately classified as a financing activity apart from other income tax cash flows. The standard also clarifies that all cash payments made on an employee’s behalf for withheld shares should be presented as a financing activity on the statement of cash flows, and provides an accounting policy election to account for forfeitures as they occur. The new standard is effective for the Company’s calendar year beginning January 1, 2017. On January 1, 2017, as a result of adopting ASU No. 2016-09, the Company recorded a cumulative-effect adjustment of $1.1 million between retained earnings and additional paid in capital as the Company elected to recognize forfeitures as they occur. Additionally, a retrospective adjustment to the Company’s statement of cash flows for the nine months ended September 30, 2016 resulted in an increase of $460,000 to net cash provided by operating activities and a decrease of $460,000 to net cash provided by financing activities.

In January 2017, the FASB issued ASU No. 2017-01, “Clarifying the Definition of a Business.” This definition, as defined in ASC 805, is used in determining whether acquisitions are accounted for as business combinations or as the acquisition of assets. This standard modifies the definition of a business, including providing a screen to determine when an acquired set of assets and activities is not a business. The screen requires that when substantially all of the fair value of the gross assets acquired is concentrated in a single identifiable asset or a group of similar identifiable assets, the set is not a business. The standard also makes other modifications to clarify what must be included in an acquired set for it to be a business and how to evaluate the set to determine whether it is a business. The Company’s acquisitions subsequent to December 31, 2016, such as the acquisition of Vtesse, are subject to the application of the modified definition.

In January 2017, the FASB issued ASU No. 2017-04, “Intangibles - Goodwill and Other (Topic 350): Simplifying the test for goodwill impairment.” ASU No. 2017-04 simplifies the subsequent measurement of goodwill by eliminating Step 2 in the quantitative test and requires an entity to record an impairment charge based on the excess of a reporting unit’s carrying amount over its fair value. ASU 2017-04 will be applied prospectively and is effective for annual and interim goodwill impairment tests conducted in fiscal years beginning after December 15, 2019. The new standard is effective for the Company for its fiscal 2021 fourth quarter goodwill impairment test. Early adoption is permitted for annual and interim goodwill impairment testing dates after January 1, 2017. The Company elected to early adopt ASU No. 2017-04 on January 1, 2017. The adoption had no impact on the Company’s consolidated financial statements as of and for the three and nine months ended September 30, 2017.

In May 2017, the FASB issued ASU No. 2017-09, “Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting”. ASU 2017-09 provides guidance about which changes to the terms or conditions of a share-based payment award require an entity to apply modification accounting in Topic 718. An entity should account for the effects of a modification unless all the following are met: 1) the fair value of the modified award is the same as the fair value of the original award immediately before the original award is modified, 2) the vesting conditions of the modified award are the same as the vesting conditions of the original award immediately before the original award is modified, and 3) the classification of the modified award as an equity instrument or a liability instrument is the same as the classification of the original award immediately before the original award is modified. The amendment in ASU No. 2017-09 is effective for public business entities for annual periods beginning after December 15, 2017 and is to be applied prospectively. Early adoption is permitted, including adoption in any interim period. The Company adopted ASU No. 2017-09 on July 1, 2017.

Accounting Pronouncements Not Yet Adopted 

In May 2014, the FASB issued ASU No. 2014-09, “Revenue from Contracts with Customers”, which will replace numerous requirements in GAAP, including industry-specific requirements. This guidance provides a five-step model to be applied to all contracts with customers, with an underlying principle that an entity will recognize revenue to depict the transfer of goods or services to customers at an amount that the entity expects to be entitled to in exchange for those goods or services.  The FASB has issued several amendments to the standard including clarification on accounting for licenses of intellectual property, identifying performance obligations, and most recently, technical corrections on the interpretation of the new guidance. ASU No. 2014-09 requires extensive quantitative and qualitative disclosures covering the nature, amount, timing and uncertainty of revenue and cash flows arising from customer contracts, including disclosures on significant judgments made when applying the guidance. This guidance is effective for annual reporting periods beginning after December 15, 2017 and interim periods therein. An entity can elect to apply the guidance under one of the following two methods: (i) retrospectively to each prior reporting period presented – referred to as the full retrospective method or (ii) retrospectively with the cumulative effect of initially applying the standard recognized at the date of initial application in retained earning – referred to as the modified retrospective method.

The Company has established a project team in order to analyze the effect of the standard on its revenue streams by reviewing its current accounting policies and practices to identify potential differences which would result from applying the requirements of the new standard to its revenue contracts. The Company has identified each revenue stream and is nearing the completion of its assessment of all potential effects of the standard. The Company continues to evaluate the impact of adoption. The Company plans to adopt the new standard effective January 1, 2018, applying the modified retrospective method. The adoption of ASU No. 2014-09 will at least impact the timing of certain product sales revenues that are currently being recognized using the sell-through method.  We anticipate that the adoption of ASU 2014-09 will result in earlier recognition of these product sales revenues and will create an adjustment to the Company’s accumulated deficit balance.

In February 2016, the FASB issued ASU No. 2016-02, “Leases,” that requires lessees to recognize assets and liabilities on the balance sheet for most leases including operating leases. Lessees now classify leases as either finance or operating leases and lessors classify all leases as sales-type, direct financing or operating leases. The statement of operations presentation and expense recognition for lessees for finance leases is similar to that of capital leases under Accounting Standards Codification (ASC) 840 with separate interest and amortization expense with higher periodic expense in the earlier periods of a lease. For operating leases, the statement of operations presentation and expense recognition is similar to that of operating leases under ASC 840 with single lease cost recognized on a straight-line basis. This guidance is to be applied using a modified retrospective approach at the beginning of the earliest comparative period presented in the financial statements and is effective for annual periods beginning after December 15, 2018 and interim periods therein. Early adoption is permitted. The Company is currently evaluating the effect ASU No. 2016-02 may have on its condensed consolidated financial statements and related disclosures, but expects recognizing the lease liability and related right-of-use asset will impact its consolidated balance sheet.

In March 2017, the FASB issued ASU No. 2017-07, “Compensation—Retirement Benefits (Topic 715): Improving the Presentation of Net Periodic Pension Cost and Net Periodic Postretirement Benefit Cost.” ASU No. 2017-07 requires that an employer report the service cost component in the same line item or items as other compensation costs arising from services rendered during the period. The other components of net benefit cost are required to be presented in the income statement separately from the service cost component and outside a subtotal of income from operations, if one is presented. The amendments in this ASU No. 2017-07 also allow only the service cost component to be eligible for capitalization when applicable. The amendments in ASU No. 2017-07 are effective for public business entities for annual periods beginning after December 15, 2017 and are to be applied retrospectively, including interim periods within those annual periods. Early adoption is permitted as of the beginning of an annual period for which financial statements (interim or annual) have not been issued or made available for issuance. The Company is currently analyzing the impact of ASU No. 2017-07, and is currently unable to determine the impact of the new standard, if any, on the Company’s consolidated financial statements.

3. Net Income (Loss) per Share

Basic net loss per share is computed by dividing net loss by the weighted average common shares outstanding. Diluted net loss per share is computed by dividing net loss by the weighted average common shares outstanding without the impact of potential dilutive common shares outstanding because they would have an anti-dilutive impact on diluted net loss per share. The treasury-stock method is used to determine the dilutive effect of the Company’s stock option grants, and the if-converted method is used to determine the dilutive effect of the Company’s convertible notes.

The computation of net loss per share for the three and nine months ended September 30, 2017 and 2016 is shown below.

The outstanding options to purchase common stock and the shares issuable under the Convertible Note utilizing the if-converted method were excluded from the computation of diluted net income per share as their effect would have been anti-dilutive for the periods presented below:

4. Segment Information

The Company has one operating segment which is the development and commercialization of pharmaceutical products. Summarized product category and geographic information is shown in the tables below.

Product Category Information

Revenues for product categories are attributed based on the following categories.

Product sales revenue represents drug product net sales of AMITIZA in North America, Japan and Europe and drug product net sales of RESCULA in Japan. Research and development revenue represents funded development work primarily related to AMITIZA. Product royalty revenue represents royalty revenue earned on the net sales of AMITIZA in North America. Contract and collaboration revenue represents the amortization of up-front payments under the North America Takeda Agreement and release of the collaboration obligation under the Global Takeda Agreement.

Company revenues by product category were as follows:

Geographical Information

Revenues are attributable to countries based on the location of the customer. The Company operates a manufacturing facility in Japan that supplies products to customers as well as the Company’s subsidiaries in other countries. The sales from the manufacturing operations to other countries are included in the net sales of the country in which the manufacturing location is based. All intercompany sales are excluded to derive consolidated revenues. The Company’s country of domicile is the United States.

Company revenues by geographic location were as follows:

The Company’s property and equipment, net by geographic location where located on September 30, 2017 and December 31, 2016 were as follows:

5. Asset Acquisition

The following table and narrative summarizes the Company’s asset acquisition during the nine months ended September 30, 2017.

In April 2017, the Company acquired Vtesse, including its Phase 2b/3 product candidate, VTS-270 (the IPR&D asset), a well-characterized mixture of HPßCD with a specific compositional fingerprint that distinguishes it from other HPßCD mixtures, for the treatment of NPC-1, an ultra-orphan, progressive and fatal disease. Under the terms of the agreement, the Company acquired Vtesse for upfront consideration of $212.0 million and agreed to pay contingent consideration based on mid-single digit to double-digit royalties on global net sales of the product based on increasing net sales levels, and a share of net proceeds that may be generated from the monetization of a pediatric review voucher, which the Company expects to be granted in connection with U.S regulatory approval of VTS-270. Of the $212.0 million consideration, the Company made a cash payment of $182.0 million and issued $30.0 million of Treasury Stock, in the form of 2,782,678 Class A common shares, based upon the closing price of $10.78 on April 3, 2017, to former Vtesse stockholders.

The following summarizes the preliminary purchase price allocation:

Vtesse did not meet the definition of a business under ASC 805, as substantially all of the fair value of Vtesse was attributable to the VTS-270 IPR&D asset. Based on the asset acquisition method of accounting, the consideration paid was allocated primarily to the IPR&D asset acquired of $186.6 million, which was immediately expensed as the IPR&D asset has no other alternate use. The balance was allocated to the remaining assets and liabilities based on their estimated fair values. The acquired IPR&D expense is not tax deductible.

6. Fair Value Measurements

The Company performs fair value measurements in accordance with the FASB’s guidance for fair value measurements and disclosures, which defines fair value as the exchange price that would be received for selling an asset or paid to transfer a liability in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. A fair value hierarchy is established which requires the Company to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. The Company classifies its assets and liabilities into the following categories based on the three levels of inputs used to measure fair value:

Level 1: Observable inputs, such as quoted prices in active markets for identical assets or liabilities;

Level 2: Inputs, other than the quoted price in active markets, that are observable, either directly or indirectly, such as quoted prices in active markets for similar assets or liabilities, quoted prices for identical or similar assets or liabilities in markets that are not active, or other inputs that are observable or can be corroborated by observable market data for substantially the full term of the assets or liabilities; or

Level 3: Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

The carrying values of cash and cash equivalents, restricted cash, accounts receivable, product royalties receivable, accounts payable and other accrued liabilities, approximate their fair values due to their short maturities.

The Company has elected the fair value option on its investment in CPP; as such, it is measured at fair value on a recurring basis and was classified as Level 2. At September 30, 2017, the estimated fair value of the investment in CPP was $10.4 million. For the three months ended September 30, 2017, the Company recorded $0.1 million in other income due to the increase in fair value of the investment in CPP.

The estimated fair value of the Company’s long-term debt at September 30, 2017 was $309.0 million, was classified as Level 2, and was based on available market data as of September 30, 2017.

The estimated fair values may not represent actual values of the financial instruments that could be realized as of the balance sheet date or that will be realized in the future. As of September 30, 2017 and December 31, 2016, there were no financial instruments measured at fair value on a non-recurring basis.

7. Inventory

Inventories are stated at the lower of cost and net realizable value with cost being determined using a standard cost method, which approximates average cost. Inventories consist of raw materials, work-in-process and finished goods. The Company’s inventories include the direct purchase cost of materials and supplies and manufacturing overhead costs.

Inventory consisted of the following at September 30, 2017 and December 31, 2016:

8. Investments, Non-Current

Investment in CPP

In 2016, the Company entered into a Securities Purchase Agreement (CPP Securities Agreement) and an Option and Collaboration Agreement (CPP Option Agreement) with CPP for the development and commercialization of CPP-1X/sulindac combination.

Under the terms of the CPP Securities Agreement, the Company provided $5.0 million in January 2016 and $5.0 million in September 2017 to CPP in exchange for convertible notes. Both convertible notes bear interest at the rate of 5% per annum. The January 2016 and the September 2017 convertible notes mature on January 31, 2019 and September 6, 2020, respectively, unless earlier converted or prepaid.

Under the terms of the CPP Option Agreement, CPP granted the Company the sole option to acquire an exclusive license to commercialize CPP-1X/Sulindac combination product in North America. CPP-1X/Sulindac is currently in a Phase 3 clinical trial for the treatment of FAP. Target enrollment in the study was achieved in April 2016 and the trial is expected to conclude in 2018. The Company agreed to pay CPP an option fee of $7.5 million, payable in two tranches. The first tranche of $3.0 million was paid in January 2016 upon signing.  On June 7, 2017, CPP informed the Company that an IDMC, following a planned interim futility analysis, found no reason to discontinue the Phase 3 study. Pursuant to the Company’s agreement with CPP, the Company made a $4.5 million payment for the second option fee tranche, which was recorded as research and development expense for the nine months ended September 30, 2017.

CPP is considered to be a VIE with respect to the Company. Following the $4.5 million license option tranche payment and $5.0 million investment, the Company reassessed whether it is the primary beneficiary of CPP. The Company concluded that the power to direct the activities that most significantly impact CPP’s economic performance continues to be held by the board of directors and management of CPP. The Company does not have a voting representative on CPP’s board and does not have the right to appoint or elect such a voting representative. Therefore, the Company is not the primary beneficiary of CPP, and the entity is not consolidated with the financial statements of the Company.

The Company’s maximum exposure to loss as a result of its involvement with CPP was $10.4 million and $5.2 million as of September 30, 2017, and December 31, 2016, respectively.

The Company has elected the fair value option on the convertible notes received from CPP due to the financial characteristics of the investment. As of September 30, 2017 and December 31, 2016, the fair value of the convertible notes were $10.4 million and $5.2 million, respectively.

9. Intangible Assets

Intangible assets, net consisted of the following as of September 30, 2017 and December 31, 2016:

For each of the three months ended September 30, 2017 and 2016, the Company recorded amortization expense of $6.7 million. For the nine months ended September 30, 2017 and 2016, the Company recorded amortization expense of $20.3 million and $18.9 million, respectively.

10. Accrued Expenses and Other Current Liabilities

Accrued expenses consisted of the following at September 30, 2017 and December 31, 2016:

Other current liabilities consisted of the following at September 30, 2017 and December 31, 2016:

11. Other Liabilities

Other liabilities consisted of the following at September 30, 2017 and December 31, 2016:

12. Debt

On December 27, 2016, the Company issued $300.0 million aggregate principal amount of its 3.25% Convertible Senior Notes due in 2021 (the Convertible Notes). Interest is payable semi-annually in cash in arrears on June 15 and December 15 of each year, beginning on June 15, 2017, at a rate of 3.25% per year. The Convertible Notes mature on December 15, 2021 unless earlier converted or repurchased, are not redeemable prior to the maturity date and no sinking fund is provided for the Convertible Notes.

As of September 30, 2017, the Company was in compliance with all covenants and conditions under the Convertible Notes.

The Convertible Notes are subject to the fair value disclosure requirements as discussed in Note 6 and are classified as a Level 2 instrument. The estimated fair value of the Convertible Notes at September 30, 2017 and December 31, 2016 was $309.0 million and $319.5 million, respectively.

Total future interest and debt principal repayment obligations related to the Convertible Notes were as follows as of September 30, 2017:

On October 31, 2017, the Company, as borrower, entered into a credit agreement, (Credit Agreement) with JPMorgan Chase Bank, N.A., as administrative agent, and the lenders, providing for (i) a three-year, $100 million revolving loan facility and (ii) an uncommitted accordion facility subject to the satisfaction of certain conditions (collectively, the Facility). The Facility includes a $50 million multicurrency subfacility, a $5 million letter of credit subfacility and a $5 million swing line loan subfacility. Loans under the Facility bear interest, at the Company’s option, at a rate equal to either (a) the LIBOR rate, plus an applicable margin ranging from 2.50% to 3.50% per annum, based upon the total net leverage ratio, or (b) the prime lending rate, plus an applicable margin ranging from 1.50% to 2.50% per annum, based upon the total net leverage ratio. Any borrowings of the Facility through the end of 2018 will be fixed to an interest rate of LIBOR plus 300 basis points.

The Company can borrow under the Facility through October 31, 2020, at which time the Facility expires and all outstanding principal amounts will be due and payable. The Facility is secured by all tangible and intangible assets of the Company and certain of its subsidiaries, except for certain customary excluded assets, and 65% of the capital stock of certain of the Company’s foreign subsidiaries. Any undrawn amount of the Facility will accrue a commitment fee of 0.50% through the end of 2018. The commitment fee for any undrawn amount of the Facility after 2018 may fluctuate based on the Company’s total net leverage ratio for the remainder of the term. The Facility requires the Company to comply with financial covenants, including a maximum senior secured net leverage ratio, minimum liquidity and minimum EBITDA covenants. There was no outstanding balance under the Facility as of the date of issuance of these financial statements.

13. Commitments and Contingencies

Operating Leases

The Company leases office space in the United States, Switzerland and Japan under operating leases through 2027. Total future minimum, non-cancelable lease payments under operating leases as of September 30, 2017 were as follows:

Rent expense for all operating leases was $0.4 million and $0.7 million for the three months ended September 30, 2017 and September 30, 2016, respectively and $1.2 million and $2.0 million for the nine months ended September 30, 2017 and 2016, respectively.

CPP

As described in Note 8, under the terms of the CPP Option Agreement, CPP granted the Company the sole option to acquire an exclusive license to commercialize CPP-1X/Sulindac combination product in North America.

Upon exercise of its exclusive option, the Company would acquire the rights to negotiate an exclusive license to develop and commercialize the product in North America for all indications. In connection with the execution of the definitive license agreement, the Company could be obligated to pay CPP up to an aggregate of $190.0 million of specified license fees and clinical development and sales milestones. The first such payment to CPP would be due upon the execution of the license agreement; the amount of the license fee will be $5.0 million if the Company’s option is exercised prior to the completion of the CPP FAP-310 trial or $10.0 million if the license agreement is exercised after such completion. Under the terms of the license, the Company and CPP would share equally in net profits from the sale of licensed products.

14. Stock Option Plans

A summary of employee stock option activity for the nine months ended September 30, 2017 under the Company’s Amended and Restated 2006 Stock Incentive Plan is presented below:

A summary of employee stock option activity for the nine months ended September 30, 2017 under the Company’s 2016 Equity Incentive Plan (the “2016 Plan”) is presented below:

The weighted average grant date fair value of options granted during the nine months ended September 30, 2017 was $5.33.

A summary of employee restricted stock units activity for the nine months ended September 30, 2017 under the Company’s 2016 Plan is presented below:

Employee Stock Purchase Plan

The following table summarizes the activity under the Company’s Amended and Restated 2006 Employee Stock Purchase Plan for the nine months ended September 30, 2017 and 2016:

Accumulated Other Comprehensive Income

The following table details the accumulated other comprehensive income (loss) activity for the nine months ended September 30, 2017 and 2016:

15. Income Taxes

The provision for income taxes is based upon the estimated annual effective tax rates for the year applied to the current period income before tax plus the tax effect of any significant unusual items, discrete events or changes in tax law. The Company’s operating subsidiaries are exposed to effective tax rates ranging from zero to approximately 40%. Fluctuations in the distribution of pre-tax income among the Company’s operating subsidiaries can lead to fluctuations of the effective tax rate in the condensed consolidated financial statements. In the three months ended September 30, 2017 and 2016, the actual effective tax rates were 41% and 47.8%, respectively, and for the nine months ended September 30, 2017 and 2016, the actual effective tax rates were (8.3%) and 57.4%, respectively. The decrease in the effective tax rate for the three months ended September 30, 2017 and September 30, 2016 was due to a decrease in current U.S. income inclusions for activities captured in the Company’s controlled foreign corporations. The decrease in the effective tax rate for the nine months ended September 30, 2017 and September 30, 2016 was primarily due to the non-deductibility of the acquired in-process research and development expense during 2017. Tax expense for the three months ended September 30, 2017 decreased compared to the three months ended September 30, 2016 due to the lower effective tax rate described above. Tax expense for the nine months ended September 30, 2017 increased compared to the nine months ended September 30, 2016 primarily due an increase in earnings with no tax benefit available for the acquired in-process research and development in 2017 from Vtesse.

The Company assesses uncertain tax positions in accordance with ASC 740 (ASC 740-10 Accounting for Uncertainties in Tax). As of September 30, 2017, the Company’s net unrecognized tax benefits totaled $3.2 million, excluding interest and penalties. Of this balance, $1.7 million would favorably impact the Company’s effective tax rate in the periods if they are recognized. Management has not identified any material uncertain tax positions that are reasonably likely to be released during the next 12 months due to lapse of statutes of limitations or settlements with tax authorities.

The Company conducts business globally and, as a result, files numerous consolidated and separate income tax returns in the U.S., Switzerland and Japan, as well as in various other state and foreign jurisdictions. In the normal course of business, the Company is subject to examination by taxing authorities throughout the world. Currently tax years 2012 to 2016 remain open and subject to examination in the major tax jurisdictions in which tax returns are filed. The tax years 2009-2011 were examined by the U.S. tax authorities and resulted in no tax adjustments. On October 18, 2017, the Company was informed its Japanese subsidiaries’ 2013 through 2017 Japanese income tax returns are under audit by the  Japan Tax Authority (Regional Taxation Bureau).