ARENA PHARMACEUTICALS
You should read the following discussion and analysis in conjunction with "Item
8. Financial Statements and Supplementary Data" included below in this Annual
Report on Form 10-K, or Annual Report. Operating results are not necessarily
indicative of results that may occur in future periods.
This discussion and analysis contains forward-looking statements that involve a
number of risks, uncertainties and assumptions. Actual events or results may
differ materially from our expectations. Important factors that could cause
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actual results to differ materially from those stated or implied by our forward-looking statements include, but are not limited to, those set forth in "Item 1A. Risk Factors" in this Annual Report. All forward-looking statements included in this Annual Report are based on information available to us as of the time we file this Annual Report and, except as required by law, we undertake no obligation to update publicly or revise any forward-looking statements. In addition, statements that "we believe" and similar statements reflect our beliefs and opinions on the relevant subject. These statements are based upon information available to us as of the date of this Annual Report, and while we believe such information forms a reasonable basis for such statements, such information may be limited or incomplete, and our statements should not be read to indicate that we have conducted an exhaustive inquiry into, or review of, all potentially available relevant information. These statements are inherently uncertain.
Pending Transaction with Pfizer
OnDecember 12, 2021 , Arena entered into an Agreement and Plan of Merger (the "Merger Agreement") with Pfizer Inc., aDelaware corporation ("Parent"), andAntioch Merger Sub, Inc. , aDelaware corporation and wholly owned subsidiary of Parent ("Merger Sub"), providing for, among other things, the merger of Merger Sub with and into Arena (the "Merger"), with Arena surviving the Merger.
At the effective time of the Merger (the "Effective Time"), each:
(i) share of common stock of the Company, par value$0.0001 per share (each, a "Share"), issued and outstanding immediately prior to the Effective Time (other than (A) Shares owned by the Company as treasury stock, (B) Shares owned by Parent or Merger Sub and (C) any dissenting shares) will no longer be outstanding and will automatically be cancelled, retired and converted into the right to receive an amount in cash equal to$100.00 , without interest thereon (the "Merger Consideration")? (ii) option to purchase Shares (each, a "Company Option") granted by the Company under the Company's 2021 Long-Term Incentive Plan or prior stock plans (collectively, the "Company Stock Plans") that is outstanding as of immediately prior to the Effective Time, whether or not then vested, will be cancelled and immediately cease to be outstanding and converted into the right to receive an amount in cash equal to the product of (1) the excess, if any, of the Merger Consideration over the per-share exercise price of such Company Option, multiplied by (2) the number of Shares then subject to such Company Option? (iii) Company restricted stock unit, except as described in "(iv)" below, subject to vesting conditions based solely on continued employment or service to the Company or any of its subsidiaries granted by the Company under a Company Stock Plan that is unvested and outstanding as of immediately prior to the Effective Time will be cancelled and immediately cease to be outstanding and converted into the right to receive an amount in cash equal to the Merger Consideration; (iv) Company restricted stock unit that is granted afterDecember 12, 2021 (each, a "2022 Company RSU") that is unvested and outstanding as of immediately prior to the Effective Time will be substituted automatically with a Parent restricted stock unit with respect to that number of shares of Parent common stock (each, an "Adjusted RSU") that is equal to the product of (1) the total number of Shares subject to the 2022 Company RSU immediately prior to the Effective Time multiplied by (2)(a) the Merger Consideration divided by (b) the average of the volume-weighted average sales price per share of common stock of Parent on theNew York Stock Exchange for the consecutive period of 15 trading days ending on (and including) the trading day that is four trading days prior to the Effective Time, with any fractional shares rounded to the nearest whole share. Each Adjusted RSU will otherwise be subject to the same terms and conditions applicable to such 2022 Company RSU immediately prior to the Effective Time (including vesting terms, and subject to accelerated vesting in connection with certain qualifying terminations of employment following the Effective Time); and (v) Company restricted stock unit granted by the Company under a Company Stock Plan that is subject to performance-based vesting conditions (each, a "Company PRSU") that is unvested and outstanding as of immediately prior to the Effective Time will be cancelled and immediately cease to be outstanding and converted into the right to receive an amount in cash equal to the Merger Consideration (with all the performance-based vesting conditions associated with such Company PRSU being deemed achieved at the greater of actual completed performance at the Effective Time or at target for any Company PRSU). Consummation of the Merger is subject to certain conditions, including, but not limited to, the: (i) Company's receipt of the approval of the Company's stockholders representing a majority of the outstanding Shares (the "Company Requisite Vote"), which was obtained onFebruary 2, 2022 ; (ii) expiration or termination of any waiting periods applicable to the consummation of the Merger under the Hart-Scott-Rodino Antitrust Improvements Act of 1976 ("HSR Act") and the receipt of certain additional clearances or approvals of certain other governmental bodies applicable to the Merger? and (iii) 64
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the absence of any law or order prohibiting or making illegal the consummation of the Merger. The Merger is targeted to close in the first half of 2022.
OVERVIEW AND RECENT DEVELOPMENTS
We are a biopharmaceutical company focused on delivering novel, transformational medicines with optimized pharmacology and pharmacokinetics to patients globally. Our internally developed pipeline includes multiple potentially first- or best-in-class assets with broad clinical utility.
Our most advanced investigational clinical programs include:
•Etrasimod, which we are evaluating in a Phase 3 program for ulcerative colitis, or UC, a Phase 2b/3 program for Crohn's disease, or CD, a Phase 2 program in alopecia areata, or AA, and a Phase 2b program for eosinophilic esophagitis, or EoE. We also plan to evaluate etrasimod in a Phase 3 program in atopic dermatitis, or AD.
•APD418, for acute heart failure, or AHF, which we are evaluating in a Phase 2 trial.
•Temanogrel, a second compound in our cardiovascular therapeutic area, which we have advanced into a Phase 2 proof of mechanism study in microvascular obstruction, or MVO and initiated a Phase 2 trial in Raynaud's phenomenon secondary to systemic sclerosis, or SSc-RP.
•Olorinab, which we were evaluating for a broad range of visceral pain conditions associated with gastrointestinal diseases. We are evaluating possible strategic options for olorinab.
We continue to leverage our two decades of world-class G-protein-coupled receptor, or GPCR, target discovery research to develop breakthrough drugs and ultimately deliver these to patients with large unmet needs. Our long-term pipeline prospects include an enhanced collaboration with Beacon Discovery across a broad range of immune-mediated inflammatory targets and compounds.
We have license agreements or collaborations with various companies, including:
•United Therapeutics (ralinepag in a Phase 3 program for pulmonary arterial hypertension),
•Everest Medicines Limited (etrasimod in a Phase 3 program for UC in
•Beacon Discovery (early research platform for GPCR targets),
•Boehringer Ingelheim International GmbH (undisclosed orphan GPCR program for central nervous system - preclinical), and
•Aristea Therapeutics (RIST4721 in a Phase 2 program for the treatment of palmoplantar pustulosis and other neutrophil-mediated diseases).
To limit the spread of COVID-19, governments have taken various actions including the issuance of stay-at-home orders and social distancing guidelines, causing some businesses to suspend operations and a reduction in demand for many products from direct or ultimate customers. Accordingly, many businesses have adjusted, reduced or suspended operating activities. The impact of this pandemic has been and will likely continue to be extensive in many aspects of society, which has resulted in and will likely continue to result in significant disruptions to businesses and capital markets around the world. The extent to which COVID-19 impacts us will depend on future developments, which are highly uncertain and cannot be predicted, including new information which may emerge concerning the severity of the coronavirus and the actions to contain the coronavirus or treat its impact, among others. Beginning the week ofMarch 16, 2020 , substantially all of our workforce began working from home, either all or substantially all of the time. In addition, we have experienced delays in site initiation and participant enrollment and screening rates in certain of our clinical development programs as a result of the COVID-19 pandemic. The potential impact, if any, that these site-level delays could have on our development program timelines remains uncertain. The effects of the stay-at-home orders and our work-from-home policies may negatively impact productivity, disrupt our business and delay our development programs, and may delay our regulatory and commercialization timelines, the magnitude of which will depend, in part, on the length and severity of the restrictions and other limitations on our ability to conduct our business in the ordinary course. Our future research and development expenses and selling, general and administrative expenses may vary significantly based on developments related to the coronavirus outbreak and impact of it and COVID-19 on the costs and timing associated with the conduct of our clinical trials and other related business activities. 65
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Table of Contents Program development update. Gastroenterology ELEVATE UC constitutes our Phase 3 global registrational program to assess the safety and efficacy of once-daily etrasimod 2 mg in participants with moderately to severely active UC. InJanuary 2021 , the pivotal, 52-week ELEVATE UC 52 trial completed enrollment. InAugust 2021 , the pivotal, 12-week ELEVATE UC 12 trial reached full enrollment. We expect topline data from both ELEVATE UC 12 and ELEVATE UC 52 in the first quarter of 2022. InNovember 2021 , we reached target enrollment of 70 participants in Study A of the Phase 2/3 CULTIVATE trial evaluating the safety and efficacy of 2 mg and 3 mg etrasimod, a highly selective, once-daily, oral sphingosine 1-phosphate (S1P) receptor modulator, in participants with moderate to severe Crohn's disease (CD). InFebruary 2021 , we dosed the first participant in our Phase 2b VOYAGE trial of etrasimod in EoE. VOYAGE is a Phase 2b randomized, double-blind, placebo-controlled trial, with a primary efficacy measurement at week 16 and a secondary efficacy analysis at week 24, to assess the safety and efficacy of 1 mg and 2 mg etrasimod in participants with EoE. InJune 2021 , the FDA granted Orphan Drug Designation status to etrasimod for the treatment of eosinophilic esophagitis. Dermatology InJuly 2021 , we evaluated an updated open-label extension ("OLE") data set from the Phase 2 ADVISE trial for 2 mg etrasimod in atopic dermatitis which demonstrated meaningful effects at week 16 of the OLE period on validated Investigator Global Assessment ("vIGA") at 47%, Eczema Area and Severity Index ("EASI -75") at 72%, and Peak Pruritis Numeric Rating Scale ("PP-NRS") at 61% with consistent safety profile out to one year. InJuly 2021 , the Phase 2 trial for etrasimod in alopecia areata was amended to add a 3 mg cohort and expand patient population subtypes. We expect to announce topline data for this trial in the second half of 2022.
Cardiovascular
In
In
In
Collaborations and license agreements update.
In
In 2020, we entered into a multi-year strategic collaboration and license
agreement ("2020 Collaboration and License Agreement") with Beacon, aimed at
building novel medicines across a range of GPCR targets believed to play a role
in immune and inflammatory diseases. Under the terms of this agreement, Beacon
is responsible for early drug discovery activities and we are responsible for
any potential future development and, ultimately, commercialization activities.
We are required to pay Beacon research initiation fees, make quarterly research
funding payments for the duration of Beacon's research activities as well as
research, development and regulatory milestone payments. We are also obligated
to pay Beacon tiered royalties on net sales of low single digits levels. In the
first quarter of 2021, we received a $1.1 million payment as a result of the
merger between Eurofins Beacon Discovery Holdings, Inc. ("Eurofins") and Beacon.
This payment satisfied Beacon's obligation to pay us a percentage of the
consideration for such sale transaction in the event that Beacon was sold as
outlined in the 2016 License and Collaboration Agreement. We are eligible to
receive future contingent consideration payments based on certain performance
metrics achieved by Beacon over a four-year performance period through the first
quarter of 2025 up to an aggregate of $2.0 million . Following the merger, we
entered
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into a Consent and Release Agreement that terminated our rights of negotiation and rights of first refusal to potentially obtain licenses to certain compounds discovered and developed by Beacon. In addition, the Consent and Release Agreement terminated the Company's right, under the 2016 License and Collaboration Agreement, to receive any revenue received by Beacon including upfront payments, milestone payments and royalties. The 2020 Collaboration and License Agreement with Beacon remains in effect and was not impacted by the merger.
Other corporate events.
InJuly 2021 , we announced the appointment ofDouglas J. Manion , M.D., F.R.C.P. (C), as Executive Vice President of Research & Development. InJune 2021 , we announced the appointment ofSteven J. Schoch as an independent director and as chair of the Audit Committee.
See the above "Business" section for a more complete discussion of our business.
RESULTS OF OPERATIONS
We are providing the following summary of our revenues, research and development expenses and selling, general and administrative expenses to supplement the more detailed discussion below. The dollar values in the following tables are in millions. For our discussion of the year endedDecember 31, 2020 , compared to the year endedDecember 31, 2019 , please read Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations located in our Annual Report on Form 10-K for the year endedDecember 31, 2020 , as filed with theSEC onFebruary 23, 2021 .
YEAR ENDED
Revenues
We recognized revenues of$0.1 million for the year endedDecember 31, 2021 , compared to revenues of$0.3 million for the year endedDecember 31, 2020 . Absent any new collaborations, we expect our 2022 revenues will primarily consist of potential milestone payments from our existing collaborations and license agreements. Revenues from milestones and royalties are difficult to predict, and our overall revenues will likely continue to vary from quarter to quarter and year to year. In the short term, we expect the amount of revenue we earn to fluctuate.
Research and development expenses
Research and development expenses, which account for the majority of our
expenses, consist primarily of clinical trial costs (including payments to
contract research organizations, or CROs), salaries and other personnel costs,
preclinical study fees, manufacturing costs for non-commercial products,
research supply costs and facility and equipment costs. We expense research and
development costs as they are incurred when these expenditures have no
alternative future uses. We generally do not track our earlier-stage, internal
research and development expenses by project; rather, we track such expenses by
the type of cost incurred.
Years ended December 31, % change from
Type of expense 2021 2020 2020 to 2021
External clinical and preclinical study fees $ 296.0 $ 220.4 34.3 %
Salary and other personnel costs (excluding non-cash share-based compensation)
75.7 64.7 17.0 %
Non-cash share-based compensation 33.5 26.0 28.8 %
Facility and other costs 14.3 12.6 13.5 %
Total research and development expenses $ 419.5 $ 323.7 29.6 %
Research and development expenses increased by $95.8 million to $419.5 million
for the year ended December 31, 2021 , from $323.7 million for the year ended
December 31, 2020 . The increase in external clinical and preclinical study fees
was primarily due to the progression of the etrasimod UC and CD programs as well
as the temanogrel and APD418 programs, partially offset by a decrease in
olorinab program expenses. The increase in salary and other personnel costs and
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non-cash share-based compensation was primarily due to an increase in the number of research and development employees and compensation expense related to RSUs and PRSUs. Of the$296.0 million external clinical and preclinical study fees noted in the table above for the year endedDecember 31, 2021 ,$250.9 million relates to etrasimod. Of the$220.4 million external clinical and preclinical study fees noted in the table above for the year endedDecember 31, 2020 ,$170.7 million relates to etrasimod. Cumulatively from our inception throughDecember 31, 2021 , we have recognized (i) external clinical and preclinical study fees of$307.8 million for lorcaserin,$616.0 million for etrasimod,$64.2 million for ralinepag,$43.8 million for nelotanserin,$67.1 million for olorinab and$27.8 million for temanogrel and (ii)$53.2 million for non-commercial manufacturing and other development costs for lorcaserin and, to a lesser extent, nelotanserin. We expect to incur substantial research and development expenses in 2022 and for the aggregate amount in 2022 to be greater than the amount incurred in 2021. We expect our research and development costs to be higher primarily due to a higher number of clinical studies and associated external clinical trial costs and increasing headcount in connection with advancing our pipeline. Our actual expenses may be higher or lower than anticipated due to various factors, including our progress and results. For example, patient enrollment in our Phase 3 clinical program for etrasimod is expected to be competitive and challenging, and could take longer than originally projected, which may result in our related external expenses being lower in 2022 than anticipated (but which might increase the overall costs for completing this multi-year program). Expenditures on current and future clinical development programs are expected to be substantial and subject to many uncertainties, which include having adequate funding and developing our drug candidates independently or with collaborators. As a result of such uncertainties, we cannot predict with any significant degree of certainty the duration and completion costs of our research and development projects or whether, when and to what extent we will generate revenues from the commercialization and sale of any of our drug candidates. The duration and cost of clinical trials may vary significantly over the life of a project as a result of unanticipated events arising during clinical development and a variety of factors, including:
•the nature and number of trials and studies in a clinical program;
•the potential therapeutic indication;
•the number of patients who participate in the trials;
•the number and location of sites included in the trials;
•the rates of patient recruitment, enrollment and withdrawal;
•the duration of patient treatment and follow-up;
•the costs of manufacturing drug candidates; and
•the costs, requirements, timing of, and the ability to secure and maintain regulatory approvals.
Acquired in-process research and development
InJuly 2021 , we entered into a strategic collaboration and option agreement withAristea to advance the clinical development of RIST4721, an oral CXCR2 antagonist. We made a$60.0 million upfront payment and$10.0 million investment inAristea's preferred stock, both of which were expensed as acquired in-process research and development expenses in the consolidated statement of operations during the year endedDecember 31, 2021 .
Selling, general and administrative expenses
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Years ended December 31, % change from
Type of expense 2021 2020 2020 to 2021Salary and other personnel costs (excluding non-cash share-based compensation)
$ 41.5 $ 31.8 30.5 % Non-cash share-based compensation 36.9 33.9 8.8 % Legal, accounting and other professional fees 31.8 23.8 33.6 % Facility and other costs 16.0 13.7 16.8 % Total selling, general and administrative expenses$ 126.2 $ 103.2 22.3 % Selling, general and administrative expenses increased by$23.0 million to$126.2 million for the year endedDecember 31, 2021 , from$103.2 million for the year endedDecember 31, 2020 . The increase in salary and other personnel costs and non-cash share-based compensation was primarily due to an increase in the number of selling, general and administrative employees and compensation expense related to RSUs and PRSUs. The increase in legal, accounting and other professional fees was primarily related to legal expenses associated with the ongoing BELVIQ litigation as well as marketing and commercialization costs associated with early commercialization preparedness. The increase in facility and other costs was primarily due to increased software license subscriptions and computer equipment purchases associated with higher headcount and new system implementations. Transaction costs InDecember 2021 , we entered into a definitive agreement under which Pfizer, Inc. will acquire all of Arena's outstanding shares. In connection with this transaction, we incurred transaction fees of approximately$7.3 million . In addition to the transaction fees associated with the Pfizer transaction, we also incurred approximately$1.3 million of fees related to theAristea transaction. These expenses are presented as transaction costs in the accompanying consolidated statements of operations. Interest and other income, net. Interest and other income, net, was$7.9 million for the year endedDecember 31, 2021 , compared to$21.9 million for the year endedDecember 31, 2020 . This change was primarily due to a decline of$9.6 million in interest income from our available-for-sale investments and an increase of$5.9 million from equity in losses from our equity method investment in Longboard. During the year endedDecember 31, 2021 , we recorded a gain from a change in ownership percentage of our equity method investment in Longboard of approximately$13.9 million and a$1.1 million gain from the Beacon Discovery merger with Eurofins. During the year endedDecember 31, 2020 , we recorded a gain of$13.0 million from deconsolidating our investment inArena Neurosciences, Inc. (now Longboard).
Income tax expense. We did not record a benefit for income taxes for the years
ended
LIQUIDITY AND CAPITAL RESOURCES
OnDecember 12, 2021 , Arena entered into an Agreement and Plan of Merger with Pfizer Inc. We have agreed to various covenants and agreements, including, among others, agreements to conduct our business in the ordinary course during the period between the execution of the Plan of Merger and the effective time of the Merger. Outside of certain 69
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limited exceptions, we may not take, authorize, commit, resolve, or agree to do certain actions without Pfizer's consent, including:
•acquiring businesses and disposing of significant assets;
•incurring expenditures above specified thresholds;
•issuing equity;
•issuing debt facilities; and
•repurchasing shares of our outstanding common stock.
We do not believe these restrictions will prevent us from meeting our ongoing costs of operations, working capital needs, or capital expenditure requirements.
We have accumulated a large deficit since inception that has primarily resulted from the significant research and development expenditures we have made in seeking to identify and develop compounds that could become marketed drugs. We expect to continue to incur substantial losses for at least the short term. To date, we have obtained cash and funded our operations primarily through the sale of common and preferred stock, the issuance of debt and related financial instruments, payments from collaborators and customers and sale leaseback transactions. From our inception throughDecember 31, 2021 , we have generated$4.0 billion in cash from these sources, of which approximately$2.5 billion was through sales of equity,$1.4 billion was through payments from collaborators and customers,$96.9 million was through the issuance of debt and related financial instruments and$77.1 million was from sale and leaseback transactions. We believe our cash resources are sufficient to allow us to continue operations for at least the next 12 months from the date this Annual Report is filed with theSEC . There is no guarantee that adequate funds will be available when needed from additional debt or equity financing, development and commercialization partnerships or from other sources, or on terms acceptable to us. If our efforts to obtain sufficient additional funds are not successful, we would be required to delay, scale back, or eliminate some or all of our research or development, manufacturing operations, administrative operations, and clinical or regulatory activities, which could negatively affect our ability to achieve certain corporate goals.
Short term liquidity
The following discussion of our short-term liquidity assumes that the Merger with Pfizer is not consummated and we continue to operate as an independent entity. During the pendency of the Merger we are restricted from pursuing financing opportunities through the manners listed in items (ii)-(iv) in the below paragraph. AtDecember 31, 2021 , we had$0.7 billion in cash and cash equivalents and available-for-sale investments. Our potential sources of liquidity in the short term include (i) milestone and other payments from collaborators, (ii) entering into new collaboration, licensing or commercial agreements for one or more of our drug candidates or programs, (iii) the lease of our facilities or sale of other assets and (iv) sale of equity, issuance of debt or other transactions.
Long term liquidity
The following discussion of our long-term liquidity assumes that the Merger with Pfizer is not consummated and we continue to operate as an independent entity.
It will require substantial cash to achieve our objectives of discovering,
developing and commercializing drugs, and this process typically takes many
years and potentially several hundreds of millions of dollars for an individual
drug. We may not have adequate available cash, or assets that could be readily
turned into cash, to meet these objectives in the long term. We will need to
obtain significant funds under our existing collaborations, under new
collaboration, licensing or other commercial agreements for one or more of our
drug candidates and programs or patent portfolios, or from other potential
sources of liquidity, which may include the sale of equity, issuance of debt or
other transactions.
In addition to potential payments from our current collaborators, as well as
funds from public and private financial markets, potential sources of liquidity
in the long term include (i) upfront, milestone, royalty and other payments from
any future collaborators or licensees and (ii) revenues from sales of any drugs
we obtain regulatory approval to commercialize on our own. The length of time
that our current cash and cash equivalents and any available borrowings will
sustain our operations is based on, among other things, the rate of adoption and
commercial success of any drugs we or our
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collaborators obtain regulatory approval to market, regulatory decisions affecting our and our collaborator's drug candidates, prioritization decisions regarding funding for our programs, progress in our clinical and earlier-stage programs, the time and costs related to current and future clinical trials and nonclinical studies, our research, development, manufacturing and commercialization costs (including personnel costs), our progress in any programs under collaborations, costs associated with intellectual property, our capital expenditures, and costs associated with securing any in-licensing opportunities. Any significant shortfall in funding may result in us reducing our development and/or research activities, which, in turn, would affect our development pipeline and ability to obtain cash in the future. We evaluate from time to time potential acquisitions, in-licensing and other opportunities. Any such transaction may impact our liquidity as well as affect our expenses if, for example, our operating expenses increase as a result of such acquisition or license or we use our cash to finance the acquisition or license. Sources and uses of our cash
Net cash used in operating activities was
Net cash provided by investing activities was$321.4 million in the year endedDecember 31, 2021 compared to net cash used in investing activities of$21.4 million in the year endedDecember 31, 2020 . This change was primarily due to a decrease of$421.4 million in purchases of available-for-sale investments, partially offset by a$70.0 million payment toAristea inJuly 2021 for acquired in-process research and development. Net cash of$135.4 million was provided by financing activities in the year endedDecember 31, 2021 , primarily as a result of proceeds from the issuance of common stock under the ATM facility. Net cash of$350.6 million was provided by financing activities in the year endedDecember 31, 2020 , primarily as a result of proceeds from the issuance of common stock in a public offering.
Contractual Obligations
Our financing obligations relate to sale and leaseback transactions for certain of our properties. We have applied the financing method to these sale and leaseback transactions, which requires that the book value of the properties and related accumulated depreciation remain on our balance sheet with no sale recognized. The sales price of the properties is recorded as a financing obligation and a portion of each lease payment is recorded as interest expense. AtDecember 31, 2021 , we expect our interest expense over the remaining term of these leases to total$12.6 million . Our other properties are under operating leases.
CRITICAL ACCOUNTING POLICIES AND MANAGEMENT ESTIMATES
TheSEC defines critical accounting policies as those that are, in management's view, important to the portrayal of our financial condition and results of operations and demanding of management's judgment. Our discussion and analysis of financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with the US generally accepted accounting principles, or GAAP. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and related disclosures. We base our estimates on historical experience and on various assumptions that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from those estimates. Our significant accounting policies are more fully described in Note 1 of the consolidated financial statements included in this Annual Report. As disclosed in Note 1, the preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about future events that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ significantly from those estimates. We believe that the following discussion addresses our most critical accounting policies, which are those that are most important to the portrayal of our financial condition and results of operations and require management's most difficult, subjective and complex judgments. 71
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Revenue recognition. Our revenues to date have been generated primarily through
collaboration or license agreements. Our collaboration and license agreements
frequently contain multiple types of promised goods or services including (i)
intellectual property licenses, (ii) product research, development and
regulatory services and (iii) product manufacturing. Consideration we receive
under these arrangements may include upfront payments, research and development
funding, cost reimbursements, milestone payments, payments for product sales and
royalty payments.
We recognize revenue when a customer obtains control of promised goods or
services. The amount of revenue recognized reflects the consideration that we
expect to be entitled to receive in exchange for these services and excludes
sales incentives and amounts collected on behalf of third parties. We analyze
the nature of these performance obligations in the context of individual
collaboration and license agreements in order to assess the distinct performance
obligations. We apply the following five steps to recognize revenue:
i)Identify the contract with a customer. We consider the terms and conditions of
our collaboration and license agreements to identify contracts within the scope
of ASC 606. We consider that we have a contract with a customer when the
contract is approved, we can identify each party's rights regarding the goods
and services to be transferred, we can identify the payment terms for the goods
and services, we have determined the customer has the ability and intent to pay
and the contract has commercial substance. We use judgment in determining the
customer's ability and intent to pay, which is based upon factors including the
customer's historical payment experience or, for new customers, credit and
financial information pertaining to the customers.
ii)Identify the performance obligations in the contract. Performance obligations
in our collaboration and license agreements are identified based on the goods
and services that will be transferred to the customer that are both capable of
being distinct, whereby the customer can benefit from the service either on its
own or together with other resources that are readily available from third
parties or from us, and are distinct in the context of the contract, whereby the
transfer of the services is separately identifiable from other promises in the
contract. Our performance obligations generally consist of intellectual property
licenses, research, development and/or regulatory services and manufacturing and
supply commitments. Determining whether a promised goods or service is a
separate performance obligation requires the use of significant judgment. A
change in such judgment could result in a significant change in the period in
which revenue is recognized.
Most of our collaboration and license agreements with customers contain multiple
promised goods or services. Based on the characteristics of the promised goods
and services we analyze whether they are separate or combined performance
obligations. The transaction price is allocated to the separate performance
obligations on a relative standalone selling price basis. We determine
standalone selling price based on our overall pricing and discounting
objectives, taking into consideration the type of services, estimates of hourly
market rates, and stage of the research, development or clinical trials.
iii)Determine the transaction price. We determine the transaction price based on
the consideration to which we expect to be entitled in exchange for transferring
goods and services to the customer. In determining the transaction price, any
variable consideration would be considered, to the extent applicable, if, in our
judgment, it is probable that a significant future reversal of cumulative
revenue under the contract will not occur. In accordance with the royalty
exception under ASC 606 for licenses of intellectual property, the transaction
price excludes future royalty payments to be received from our customers. None
of our collaboration and license agreements contain consideration payable to our
customer or a significant financing component. The process for determining the
transaction price involves significant judgment and includes consideration of
multiple factors such as estimated revenues, market size, and development risk,
among other factors contemplated in negotiating the arrangement with the
customer.
Our contracts with customers primarily include two types of variable
consideration: (i) development and regulatory milestone payments, which are due
to us upon achievement of specific development and regulatory milestones and
(ii) one-time sales-based payments and sales-based royalties associated with
sold or licensed intellectual property.
Due to uncertainty associated with achievement of the development and regulatory
milestones, the related milestone payments are excluded from the contract
consideration and the corresponding revenue is not recognized until we conclude
it is probable that reversal of such milestone revenue will not occur.
Product sales-based royalties under licensed intellectual property and one-time
payments are accounted for under the royalty exception. We recognize revenue for
sales-based royalties under licensed intellectual property and one-time payments
at the later of when the sales occur or the performance obligation is satisfied
or partially satisfied.
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iv)Allocate the transaction price to performance obligations in the contract. If the contract contains a single performance obligation, the entire transaction price is allocated to that performance obligation. Contracts that contain multiple performance obligations require an allocation of the transaction price to each performance obligation based on a relative standalone selling price. v)Recognize revenue when or as we satisfy a performance obligation. Revenue is recognized at the time the related performance obligation is satisfied by transferring the promised goods or services to a customer. We recognize revenue when we transfer control of the goods or services to our customers for an amount that reflects the consideration that we expect to receive in exchange for those services. Performance Obligations.
The following is a description of principal goods and services from which we generate revenue.
Intellectual property licenses
We generate revenue from licensing our intellectual property including know-how and development and commercialization rights. These licenses provide customers with a term-based license to further research, develop and commercialize our internally-discovered drug candidates. The consideration we receive in the form of nonrefundable upfront consideration related to the functional intellectual property licenses is recognized when we transfer such license to the customer unless the license is combined with other goods or services into one performance obligation, in which case the revenue is recognized over a period of time based on our estimated pattern in which we satisfy the combined performance obligation. Our licensing agreements are generally cancellable. Customers have the right to terminate their contracts upon notice. We have the right to terminate the contracts generally only if the customer is in breach of the contract and fails to remedy the breach in accordance with the contractual terms. Intellectual property sales We generate royalty revenue from sales of our intellectual property. We estimate the future royalty payments and recognize revenue with a corresponding contract asset at a point in time when we transfer the intellectual property to the customer. We periodically reassess our estimate of the future royalty payments and recognize any estimate adjustments as revenue in the current period.
Research, development and regulatory services
We generate revenue from research, development and regulatory services we provide to our customers in connection with the licensed intellectual property. The services we provide to our customers primarily include scientific research activities, preparation for and management of clinical trials, and assistance during the regulatory approval application process. Revenue associated with these services is recognized based on our estimate of total consideration to be received for such services and the pattern in which we perform the services. The pattern of performance is generally determined to be the amount of incurred expenses reimbursed by the customer as a percentage of total expected reimbursable expenses associated with the contract. Clinical trial expenses. We accrue clinical trial expenses based on work performed. In determining the amount to accrue, we rely on estimates of total costs incurred based on enrollment, the completion of trials and other events. We follow this method because we believe reasonably dependable estimates of the costs applicable to various stages of a clinical trial can be made. However, the actual costs and timing of clinical trials are uncertain, subject to risks and may change depending on a number of factors. Differences between the actual clinical trial costs and the estimated clinical trial costs that we have accrued in any prior period are recognized in the subsequent period in which the actual costs become known. Historically, these differences have not been material; however, material differences could occur in the future. Share-based compensation. Our share-based awards are measured at fair value and recognized over the requisite service or performance period. We estimate the fair value of each stock option on the date of grant using the Black-Scholes option pricing model which requires the input of subjective assumptions, including price volatility of the underlying stock, risk-free interest rate, dividend yield, and expected life of the option. Expected volatility is computed using historical volatility for a period equal to the expected term. The expected term of options is determined based on historical experience of similar awards, giving consideration to the contractual terms of the share-based awards, vesting schedules and post-vesting terminations. The risk-free interest rates are based on theUS Treasury yield curve, with a 73
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remaining term approximately equal to the expected term used in the option pricing model. We account for forfeitures in the period they occur. The fair value of each restricted stock unit award is determined based on the market price of the underlying common stock on the date of the grant. We estimate the fair value of restricted stock unit awards that include market-based performance conditions on the date of grant using a Monte Carlo simulation model, based on the market price of the underlying common stock, expected performance measurement period, expected stock price volatility and expected risk-free interest rate. Income taxes. Significant judgment is required by management to determine our provision for income taxes, our deferred tax assets and liabilities, and the valuation allowance to record against our net deferred tax assets, which are based on complex and evolving tax regulations throughout the world. Our tax calculation is impacted by tax rates in the jurisdictions in which we are subject to tax and the relative amount of income earned in each jurisdiction. Our deferred tax assets and liabilities are determined using the enacted tax rates expected to be in effect for the years in which those tax assets are expected to be realized. The effect of an uncertain income tax position is recognized at the largest amount that is "more-likely-than-not" to be sustained under audit by the taxing authority. An uncertain income tax position will not be recognized if it has less than a 50% likelihood of being sustained. The realization of our deferred tax assets is dependent upon our ability to generate sufficient future taxable income. We establish a valuation allowance when it is more-likely-than-not that the future realization of all or some of the deferred tax assets will not be achieved. The evaluation of the need for a valuation allowance is performed on a jurisdiction-by-jurisdiction basis, and includes a review of all available evidence, both positive and negative. Impairment of investments. At each reporting date, we perform an evaluation of impairment of our available-for-sale investments to determine if any unrealized losses are the result of credit losses. Impairment is assessed at the individual security level. Factors considered in determining whether a loss resulted from a credit loss or other factors include the Company's intent and ability to hold the investment until the recovery of its amortized cost basis, the extent to which the fair value is less than the amortized cost basis, the financial condition of the issuer, any historical failure of the issuer to make scheduled interest or principal payments, any changes to the rating of the security by a rating agency, any adverse legal or regulatory events affecting the issuer or issuer's industry, and any significant deterioration in economic conditions. If a decline in the fair value below the amortized cost basis of available-for-sale securities is determined to be due to credit-related factors, we will record the losses in earnings through an allowance account. Unrealized gains and losses that are not credit-related are included in accumulated other comprehensive income. The above listing is not intended to be a comprehensive list of all of our accounting policies. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP. See our audited consolidated financial statements and notes thereto included elsewhere in this Annual Report, which contain additional accounting policies and other disclosures required by GAAP.
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