CervoMed Inc. - Quarter Report: 2018 September (Form 10-Q)

 

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C.  20549

 

FORM 10-Q

(Mark one)

☒

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

 

For the quarterly period ended September 30, 2018

 

☐

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

 

For the transition period from ___________ to ______________.

 

Commission file number: 000-24477

 

DIFFUSION PHARMACEUTICALS INC.

(Exact name of registrant as specified in its charter)

 

Delaware	30-0645032
(State of other jurisdiction of incorporation or organization)	(I.R.S. Employer Identification Number)

 

1317 Carlton Avenue, Suite 200
Charlottesville, VA 22902
(Address of principal executive offices, including zip code)

 

(434) 220-0718

(Registrant’s telephone number including area code)

 

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

 

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

 

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

 

Large accelerated filer ☐	Accelerated filer ☐
Non-accelerated filer ☐ (Do not check if a smaller reporting company)	Smaller reporting company ☒
	Emerging growth company ☐

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. ☐

 

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

 

The number of shares of common stock outstanding at November 1, 2018 was 50,643,429 shares.

 

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DIFFUSION PHARMACEUTICALS INC.

FORM 10-Q

SEPTEMBER 30, 2018

 

INDEX

 

	Page
PART I – FINANCIAL INFORMATION	1
ITEM 1.     FINANCIAL STATEMENTS	1
ITEM 2.     MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	16
ITEM 3.     QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	26
ITEM 4.     CONTROLS AND PROCEDURES	26
PART II – OTHER INFORMATION	27
ITEM 1.     LEGAL PROCEEDINGS	27
ITEM 1A.  RISK FACTORS	27
ITEM 2.     UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS	27
ITEM 3.     DEFAULTS UPON SENIOR SECURITIES	27
ITEM 4.     MINE SAFETY DISCLOSURES	27
ITEM 5.     OTHER INFORMATION	27
ITEM 6.     EXHIBITS	27

 

Unless the context otherwise requires, in this report, references to the “Company,” “we,” “our” or “us” refer to Diffusion Pharmaceuticals Inc. and its subsidiaries, and references to “common stock” refer to the common stock, par value $0.001 per share, of the Company.

 

This report contains the following trademarks, trade names and service marks of ours: Diffusion. All other trade names, trademarks and service marks appearing in this quarterly report on Form 10-Q are the property of their respective owners. We have assumed that the reader understands that all such terms are source-indicating. Accordingly, such terms appear without the trade name, trademark or service mark notice for convenience only and should not be construed as being used in a descriptive or generic sense.

 

 

 

		September 30, 2018				December 31, 2017
Assets
Current assets:
Cash and cash equivalents		$	11,018,441			$	8,896,468
Prepaid expenses, deposits and other current assets			551,337				769,946
Total current assets			11,569,778				9,666,414
Property and equipment, net			379,202				460,652
Intangible asset			8,639,000				8,639,000
Goodwill			2,743,208				6,929,258
Other assets			263,480				450,491
Total assets		$	23,594,668			$	26,145,815
Liabilities, Convertible Preferred Stock and Stockholders’ Equity
Current liabilities:
Current portion of convertible debt		$	—			$	550,000
Accounts payable			129,057				511,956
Accrued expenses and other current liabilities			816,620				1,628,851
Total current liabilities			945,677				2,690,807
Deferred income taxes			1,741,253				2,223,678
Other liabilities			—				1,386
Total liabilities			2,686,930				4,915,871
Commitments and Contingencies (Note 8)
Convertible preferred stock, $0.001 par value:
Series A - No shares and 13,750,000 shares authorized at September 30, 2018 and December 31, 2017, respectively. No shares and 12,376,329 shares issued at September 30, 2018 and December 31, 2017, respectively. No shares and 8,306,278 shares outstanding at September 30, 2018 and December 31, 2017, respectively.			—				—
Total convertible preferred stock			—				—
Stockholders’ Equity:
Common stock, $0.001 par value:
1,000,000,000 shares authorized; 50,572,001 and 14,519,629 shares issued and outstanding at September 30, 2018 and December 31, 2017, respectively.			50,571				14,520
Additional paid-in capital			95,210,928				82,770,313
Accumulated deficit			(74,353,761	)			(61,554,889	)
Total stockholders' equity			20,907,738				21,229,944
Total liabilities, convertible preferred stock and stockholders' equity		$	23,594,668			$	26,145,815

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		Three Months Ended September 30,								Nine Months Ended September 30,
		2018				2017				2018				2017
Operating expenses:
Research and development		$	1,169,810			$	1,759,305			$	4,386,491			$	3,946,420
General and administrative			1,589,621				1,559,399				4,748,090				4,908,424
Goodwill impairment			4,186,050				—				4,186,050				—
Depreciation			26,723				27,374				81,450				39,767
Loss from operations			6,972,204				3,346,078				13,402,081				8,894,611
Other expense (income):
Interest (income) expense, net			(37,981	)			(1,318	)			(120,784	)			73,290
Change in fair value of warrant liability			—				(8,441,616	)			—				(18,909,792	)
Warrant related expenses			—				—				—				10,225,846
Other financing expenses			—				—				—				2,870,226
(Loss) income from operations before income tax benefit			(6,934,223	)			5,096,856				(13,281,297	)			(3,154,181	)
Income tax benefit			(214,493	)			—				(482,425	)			—
Net (loss) income		$	(6,719,730	)		$	5,096,856			$	(12,798,872	)		$	(3,154,181	)
Series A cumulative preferred dividends			—				(366,641	)			(85,993	)			(912,946	)
Undistributed earnings to participating securities			—				(1,838,354	)			—				—
Deemed dividend related to the make-whole provision for the conversion of Series A convertible preferred stock into common stock			—				—				(8,167,895	)			—
Net (loss) income attributable to common stockholders		$	(6,719,730	)		$	2,891,861			$	(21,052,760	)		$	(4,067,127	)
Per share information:
Net (loss) income per share of common stock, basic		$	(0.13	)		$	0.21			$	(0.44	)		$	(0.35	)
Net (loss) income per share of common stock, diluted		$	(0.13	)		$	0.20			$	(0.44	)		$	(1.83	)
Weighted average shares outstanding, basic			50,572,001				13,937,869				47,777,757				11,709,128
Weighted average shares outstanding, diluted			50,572,001				14,714,853				47,777,757				12,525,707

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		Convertible Preferred Stock								Stockholders' Equity
		Series A								Common Stock								Additional Paid-in				Accumulated				Total Stockholders'
		Shares				Amount				Shares				Amount				Capital				Deficit				Equity
Balance at January 1, 2018			8,306,278			$	—				14,519,629			$	14,520			$	82,770,313			$	(61,554,889	)		$	21,229,944
Conversion of Series A convertible preferred stock to common stock			(8,306,278	)			—				8,306,278				8,306				(8,306	)			—				—
Issuance of common stock to Series A convertible preferred stockholders under make-whole adjustment feature			—				—				11,668,421				11,668				(11,668	)			—				—
Issuance of common stock related to accrued dividends			—				—				1,032,219				1,032				1,147,275				—				1,148,307
Series A cumulative preferred dividend			—				—				—				—				(85,993	)			—				(85,993	)
Issuance of common stock and warrants, net of issuance costs			—				—				15,000,000				15,000				10,402,520				—				10,417,520
Common stock issued for advisory services											45,454				45				24,955								25,000
Stock-based compensation expense			—				—				—				—				971,832				—				971,832
Net loss			—				—				—				—				—				(12,798,872	)			(12,798,872	)
Balance at September 30, 2018			—			$	—				50,572,001			$	50,571			$	95,210,928			$	(74,353,761	)		$	20,907,738

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		Nine Months Ended September 30,
		2018				2017
Operating activities:
Net loss		$	(12,798,872	)		$	(3,154,181	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation			81,450				39,767
Stock-based compensation expense			971,832				973,950
Common stock issued for advisory services			25,000				50,000
Warrant related expense, change in fair value, and other financing expenses			—				(5,813,720	)
Change in deferred income taxes			(482,425	)			—
Goodwill impairment			4,186,050				—
Non-cash interest expense			—				11,967
Changes in operating assets and liabilities:
Prepaid expenses, deposits and other assets			405,620				(661,675	)
Accounts payable, accrued expenses and other liabilities			(134,202	)			(1,496,150	)
Net cash used in operating activities			(7,745,547	)			(10,050,042	)
Cash flows used in investing activities:
Purchases of property and equipment			—				(438,604	)
Purchase of certificate of deposit			—				(10,000,000	)
Net cash used in investing activities			—				(10,438,604	)
Cash flows provided by financing activities:
Repayment of convertible debt principal			(550,000	)			(1,880,000	)
Proceeds from the sale of common stock			10,846,062				—
Proceeds from the sale of Series A convertible preferred stock, net			—				22,129,774
Payment of offering costs			(428,542	)			(97,980	)
Net cash provided by financing activities			9,867,520				20,151,794
Net increase (decrease) in cash and cash equivalents			2,121,973				(336,852	)
Cash and cash equivalents at beginning of period			8,896,468				1,552,852
Cash and cash equivalents at end of period		$	11,018,441			$	1,216,000
Supplemental disclosure of cash flow information
Cash paid for interest		$	40,142			$	112,800
Supplemental disclosure of non-cash investing and financing activities:
Reclassification of accrued dividends related to the issuance of common stock to Series A convertible preferred stock holders		$	1,148,307			$	—
Series A cumulative preferred dividends		$	(85,993	)		$	(912,946	)
Conversion of accrued dividends related to Series A convertible preferred stock		$	—			$	187,172

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1.	Organization and Description of Business

 

Diffusion Pharmaceuticals Inc. (“Diffusion” or the “Company”), a Delaware corporation, is a clinical stage biotechnology company focused on extending the life expectancy of cancer patients by improving the effectiveness of current standard-of-care treatments, including radiation therapy and chemotherapy. The Company is developing its lead product candidate, trans sodium crocetinate (“TSC”) for use in many cancer types in which tumor oxygen deprivation ("hypoxia") is known to diminish the effectiveness of current treatments. TSC is designed to target the cancer’s hypoxic micro-environment, re-oxygenating treatment-resistant tissue and making the cancer cells more susceptible to the therapeutic effects of standard-of-care radiation therapy and chemotherapy. Other possible uses of TSC include the treatment of hypoxic conditions such as stroke, cardiovascular disease, neurodegenerative disease and emergency medicine.

 

2.

Liquidity

 

The Company has not generated any revenues from product sales and has funded operations primarily from the proceeds of public offerings, convertible debt and convertible preferred stock. Substantial additional financing will be required by the Company to continue to fund its research and development activities. No assurance can be given that any such financing will be available when needed or that the Company’s research and development efforts will be successful.

 

The Company regularly explores alternative means of financing its operations and seeks funding through various sources, including public and private securities offerings, collaborative arrangements with third parties and other strategic alliances and business transactions. On January 22, 2018, the Company closed an underwritten public offering of 15,000,000 shares of the Company’s common stock, par value $0.001 per share (“Common Stock”) and warrants to purchase 15,000,000 shares of Common Stock. At the closing, the Company also issued warrants to purchase an additional 1,970,625 shares of Common Stock pursuant to the underwriter’s partial exercise of its overallotment option. The shares of Common Stock and warrants were sold at a combined public offering price of $0.80 per share and warrant for total proceeds of approximately $10.8 million. The warrants have an exercise price of $0.80 per share and a term of five years from the date of issuance. In addition, at the closing, the Company issued to designees of the underwriter of the offering warrants to purchase up to 750,000 shares of Common Stock. The underwriter’s warrants have an exercise price of $1.00, a term of five years from the date of issuance and otherwise substantially similar terms to the form of investor warrant. As a result of the offering, all outstanding shares of the Company's Series A convertible preferred stock converted into 21,006,918 shares of Common Stock (including accrued dividends paid-in-kind and issuance of shares in respect of the “make-whole” adjustment feature thereof).

 

The Company currently does not have any commitments to obtain additional funds and may be unable to obtain sufficient funding in the future on acceptable terms, if at all. On March 2, 2018, the Company received a written notice from the staff of the Listing Qualifications Department of the Nasdaq Stock Market LLC (the "Staff") indicating the Company was not in compliance with Nasdaq Listing Rule 5550(a)(2) (the "Minimum Bid Price Rule") because the bid price for the Company’s common stock had closed below $1.00 per share for the previous 30 consecutive business days. In accordance with Nasdaq Listing Rule 5810(c)(3)(A), the Company had 180 calendar days from the date of such notice, or until August 29, 2018, to regain compliance with the minimum bid price requirement. To regain compliance, the bid price for the Company’s Common Stock must close at $1.00 per share or more for a minimum of 10 consecutive business days. On August 30, 2018, the Company received a written notice from the Staff providing that, although the Company had not regained compliance with the Minimum Bid Price Rule by August 29, 2018, in accordance with Nasdaq Listing Rule 5810(c)(3)(F), the Staff had determined that the Company is eligible for an additional 180 calendar days from the date of such notice, or until February 25, 2019, to regain compliance with the Minimum Bid Price Rule.

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

In the event the Company is unable to regain compliance, it could adversely affect the Company’s ability to obtain future funding. If the Company cannot obtain the necessary funding, it will need to delay, scale back or eliminate some or all of its research and development programs or enter into collaborations with third parties to; commercialize potential products or technologies that it might otherwise seek to develop or commercialize independently; consider other various strategic alternatives, including a merger or sale of the Company; or cease operations. If the Company engages in collaborations, it may receive lower consideration upon commercialization of such products than if it had not entered into such arrangements or if it entered into such arrangements at later stages in the product development process. At the Company’s 2018 Annual Meeting of Stockholders on June 14, 2018, the Company’s stockholders approved an amendment to the Company’s certificate of incorporation to effect a reverse stock split of the shares of the Company’s common stock at a ratio of not less than 1-to-2 and not greater than 1-to-15, with the exact ratio and effective time of the reverse stock split to be determined by the Company’s Board of Directors, if at all.

 

The Company has prepared its financial statements assuming that it will continue as a going concern, which contemplates realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred net losses since inception and it expects to generate losses from operations for the foreseeable future primarily due to research and development costs for its potential product candidates, which raises substantial doubt about the Company’s ability to continue as a going concern. The Company currently has no sources of revenue and its ability to continue as a going concern is dependent on its ability to raise capital to fund its future business plans. Additionally, volatility in the capital markets and general economic conditions in the United States may be a significant obstacle to raising the required funds. These factors raise substantial doubt about its ability to continue as a going concern. The financial statements included herein do not include any adjustments that might be necessary should the Company be unable to continue as a going concern. If the going concern basis were not appropriate for these financial statements, adjustments would be necessary in the carrying value of assets and liabilities, the reported expenses and the balance sheet classifications used.

 

Operations of the Company are subject to certain risks and uncertainties including various internal and external factors that will affect whether and when the Company’s product candidates become approved drugs and how significant their market share will be, some of which are outside of the Company’s control. The length of time and cost of developing and commercializing these product candidates and/or failure of them at any stage of the drug approval process will materially affect the Company’s financial condition and future operations. The Company believes its cash and cash equivalents at September 30, 2018 are sufficient to fund operations in to September 2019.

 

 

3.	Basis of Presentation and Summary of Significant Accounting Policies

 

The Summary of Significant Accounting Policies included in the Company's Form 10-K for the year ended December 31, 2017, filed with the Securities and Exchange Commission on April 2, 2018 have not materially changed, except as set forth below.

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Basis of Presentation

 

The accompanying unaudited interim condensed consolidated financial statements of the Company have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”) for interim financial information as found in the Accounting Standard Codification (“ASC”) and Accounting Standards Updates (“ASUs”) of the Financial Accounting Standards Board (“FASB”), and with the instructions to Form 10-Q and Article 10 of Regulation S-X of the Securities and Exchange Commission (the “SEC”). In the opinion of management, the accompanying unaudited interim condensed consolidated financial statements of the Company include all normal and recurring adjustments (which consist primarily of accruals, estimates and assumptions that impact the unaudited interim condensed consolidated financial statements) considered necessary to present fairly the Company’s financial position as of September 30, 2018, its results of operations for the three and nine months ended September 30, 2018 and 2017 and cash flows for the nine months ended September 30, 2018 and 2017. Operating results for the nine months ended September 30, 2018 are not necessarily indicative of the results that may be expected for the year ending December 31, 2018. The unaudited interim condensed consolidated financial statements presented herein do not contain the required disclosures under GAAP for annual financial statements. The accompanying unaudited interim condensed consolidated financial statements should be read in conjunction with the annual audited financial statements and related notes as of and for the year ended December 31, 2017 filed with the SEC on Form 10-K on April 2, 2018.

 

Use of Estimates

 

The preparation of the unaudited interim condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of assets and liabilities at the date the financial statements and reported amounts of expense during the reporting period. Actual results could differ from those estimates. Due to the uncertainty of factors surrounding the estimates or judgments used in the preparation of the unaudited interim condensed consolidated financial statements, actual results may materially vary from these estimates. Estimates and assumptions are periodically reviewed and the effects of revisions are reflected in the unaudited interim condensed consolidated financial statements in the period they are deemed necessary.

 

Fair Value of Financial Instruments

 

The carrying amounts of the Company’s financial instruments, including cash equivalents, accounts payable, and accrued expenses approximate fair value due to the short-term nature of those instruments. As of December 31, 2017, the fair value of the Company’s outstanding Series B convertible debt was approximately $0.6 million. The fair value of the convertible debt was determined using a binomial lattice model that utilizes certain unobservable inputs that fall within Level 3 of the fair value hierarchy.

 

Convertible Debt

 

Upon maturity of the Series B convertible debt during the second quarter of 2018, the Company repaid the outstanding principal and interest of approximately $0.6 million and $40,000, respectively. As such, the Company does not have any debt outstanding as of September 30, 2018.

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Intangible Asset and Goodwill

 

Goodwill and intangible assets deemed to have indefinite lives are not amortized but rather are tested at least annually for impairment, or when circumstances indicate that the carrying amount of the asset may not be recoverable. If the carrying value of the reporting unit exceeds fair value, goodwill is considered impaired. In January 2017, the FASB issued revised guidance that simplifies the test for goodwill impairment, effective for fiscal years beginning after December 15, 2019, with early adoption permitted. Under the revised guidance, if a reporting unit’s carrying value exceeds its fair value, an impairment charge will be recorded to reduce the reporting unit to fair value. Prior to the revised guidance, the amount of the impairment was the difference between the carrying value of the goodwill and the "implied" fair value, which was calculated as if the reporting unit had just been acquired and accounted for as a business combination. The Company has a single reporting unit and all goodwill relates to that reporting unit. The Company's RES-529 intangible asset and goodwill are assessed for impairment annually on October 1 of the Company’s fiscal year or more frequently if impairment indicators exist. There was no impairment to the Company’s RES-529 intangible asset recognized during the three or nine months ended September 30, 2018 and 2017. During the three months ended September 30, 2018, the Company recorded a non-cash goodwill impairment of $4.2 million (see Note 5).

 

Income Taxes

 

On December 22, 2017 the President of the United States signed into law the Tax Cuts and Jobs Act ("The 2017 Tax Act"), which resulted in significant changes from previous tax law. Among other things, the 2017 Tax Act reduced the federal corporate income tax rate to 21% from 34% effective January 1, 2018 and also changed the net operating loss carryforwards’ period such that all net operating losses generated in 2018 and into the future now have an indefinite life. As a result of the change in net operating loss carryforward period, during the three and nine months ended September 30, 2018, the Company recognized an income tax benefit of $0.2 million and $0.5 million, respectively, to reflect the adjustment allowed by the 2017 Tax Act to utilize indefinite deferred tax liabilities as a source of income against indefinite lived portions of the Company’s deferred tax assets.

 

Net (Loss) Income Per Common Share

 

For the three and nine months ended September 30, 2017, the Company used the two-class method to compute net income per common share because the Company had issued securities (Series A convertible preferred stock) that entitled the holder to participate in dividends and earnings of the Company. Under this method, net income is reduced by any dividends earned during the period. The remaining earnings (undistributed earnings) were allocated to common stock and the Series A convertible preferred stock to the extent that the Series A convertible preferred stock was entitled to share in earnings as if all of the earnings for the period had been distributed. The total earnings allocated to common stock is then divided by the number of outstanding shares to which the earnings are allocated to determine the earnings per share. The two-class method is not applicable during periods with a net loss, as the holders of the convertible preferred stock would have no obligation to fund losses.

 

Diluted net (loss) income per common share is computed under the two-class method by using the weighted-average number of shares of common stock outstanding, plus, for periods with net income attributable to common stockholders, the potential dilutive effects of stock options, unvested restricted stock, warrants, and convertible debt. In addition, the Company analyzed the potential dilutive effect of the previously outstanding Series A convertible preferred stock under the “if-converted” method when calculating diluted earnings per share, in which it was assumed that the previously outstanding convertible preferred stock converted into common stock at the beginning of the period or when issued, if later. The Company would report the more dilutive of the approaches (two class or “if-converted”) as its diluted net (loss) income per share during the period.

 

For the periods in which the Company reported a net loss, there was no dilutive effect under either the two-class or “if-converted” method. For the three months ended September 30, 2017, the Company presented diluted net income per common share using the two-class method, which was more dilutive than the “if-converted” method.

 

For purposes of calculating diluted loss per common share, the denominator includes both the weighted average common shares outstanding and the number of common stock equivalents if the inclusion of such common stock equivalents would be dilutive. Dilutive common stock equivalents potentially include stock options, unvested restricted stock awards and warrants using the treasury stock method. The diluted loss per common share calculation is further affected by an add-back of change in fair value of warrant liability to the numerator under the assumption that the change in fair value of warrant liability would not have been incurred if the warrants had been converted into common stock. In addition, the Company considers the potential dilutive impact of its convertible debt instruments using the "if-converted" method.

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

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

 

 

The following potentially dilutive securities outstanding as of September 30, 2018 and 2017 have been excluded from the computation of diluted weighted average shares outstanding, as they would be anti-dilutive:

 

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Amounts in the table reflect the common stock equivalents of the noted instruments.

 

As a result of the offering of its common stock consummated in January 2018, all outstanding shares of the Company's Series A convertible preferred stock converted into shares common stock. See Note 6 of these unaudited interim condensed consolidated statements for further details.

 

Recent Accounting Pronouncements

 

In August 2018, the FASB issued ASU 2018-03, Disclosure Framework- Changes to the Disclosure Requirements for Fair Value Measurements, which changes the fair value measurement disclosure requirements of ASC 820. The goal of the ASU is to improve the effectiveness of ASC 820's disclosure requirements. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2019 and interim periods within those years. The Company is currently evaluating the potential impact of the adoption of this standard on its related disclosures.

 

In June 2018, the FASB issued ASU 2018-07, Improvements to Nonemployee Share-Based Accounting, which simplifies the accounting for share-based payments granted to nonemployees for goods and services. The ASU supersedes ASC 505-50 and expands the scope of ASC 718 to include all share-based payment arrangements related to the acquisition of goods and services from both nonemployees and employees. As a result, most of the guidance in ASC 718 associated with employee share-based payments, including most of its requirements related to classification and measurement, applies to nonemployee share-based payment arrangements.  ASU 2018-07 generally requires an entity to use a modified retrospective transition approach, with a cumulative-effect adjustment to retained earnings as of the beginning of the fiscal year of adoption, for all (1) liability-classified nonemployee awards that have not been settled as of the adoption date and (2) equity-classified nonemployee awards for which a measurement date has not been established. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2019 and interim periods within those years. The Company is currently evaluating the potential impact of the adoption of this standard on its consolidated results of operations, financial position and cash flows and related disclosures.

 

In July 2017, the FASB issued ASU 2017-11, Earnings Per Share (Topic 260); Distinguishing Liabilities from Equity (Topic 480); Derivatives and Hedging (Topic 815): (Part I) Accounting for Certain Financial Instruments with Down Round Features, (Part II) Replacement of the Indefinite Deferral for Mandatorily Redeemable Financial Instruments of Certain Nonpublic Entities and Certain Mandatorily Redeemable Noncontrolling Interests with a Scope Exception. The first part of this update addresses the complexity of accounting for certain financial instruments with down round features and the second part addresses the complexity of distinguishing liabilities from equity. The guidance is applicable to public business entities for fiscal years beginning after December 15, 2018 and interim periods within those years. The Company is currently evaluating the potential impact of the adoption of this standard on its consolidated results of operations, financial position and cash flows and related disclosures.

 

In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350) which simplifies the accounting for goodwill impairments by eliminating step 2 from the goodwill impairment test. Instead, if the carrying amount of a reporting unit exceeds its fair value, an impairment loss shall be recognized in an amount equal to that excess, limited to the total amount of goodwill allocated to that reporting unit. The standard will be effective for fiscal years beginning after December 15, 2019, including interim periods within such fiscal years. Early adoption is allowed for all entities as of January 1, 2017, for annual and any interim impairment tests occurring on or after January 1, 2017. The Company early adopted this standard in the third quarter of 2018. See Note 5 for further discussion of the Company's intangible assets, including goodwill.

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which supersedes the guidance in ASC 840, Leases. ASC 842 will be effective for the Company on January 1, 2019, and the Company expects to apply the practical expedients allowed by the standard. See Note 8 for details of the Company's current lease arrangement. While the Company continues to evaluate the provisions of ASC 842 to determine how it will be impacted, the primary effect of adopting the new standard will be to record assets and obligations for current operating leases. The adoption of ASC 842 is not expected to have a material impact on the Company's results of operations or cash flows.

 

4.	Accrued Expenses and Other Current Liabilities

 

Accrued expenses and other current liabilities consisted of the following:

 

 

 

5.	Goodwill and Intangible Assets

 

Goodwill is the excess of the cost of an acquired entity over the net amounts assigned to tangible and intangible assets acquired and liabilities assumed. The Company applies ASC 350 “Goodwill and Other Intangible Assets,” which requires testing goodwill for impairment on an annual basis. The Company evaluates goodwill on a consolidated basis as the Company is organized as a single reporting unit. The Company completes its annual impairment test on October 1 each year, or more frequently if triggering events indicate a possible impairment. The Company considers certain triggering events when evaluating whether an interim goodwill impairment analysis is warranted. Among these would be a significant long-term decrease in the market capitalization of the Company. The Company’s market capitalization was below the carrying value of equity throughout the third quarter and as a result, management concluded that the carrying value of goodwill may not be recoverable and that a triggering event requiring an interim assessment of goodwill impairment had occurred during the three months ended September 30, 2018.

 

Management performed the goodwill impairment assessment using a market approach to estimate the fair value of the Company using the Company's market capitalization. This fair value was derived by multiplying the Company's shares outstanding by the average daily close prices of the Company's stock during the third quarter. The carrying value of the Company's net equity exceeded its fair value, and accordingly, the Company recognized a $4.2 million non-cash impairment charge to goodwill that reduced the carrying value to fair value. The following table shows the changes in the carrying value of goodwill during the nine months ended September 30, 2018:

 

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTSc

 

The Company has an indefinite-lived In-Process Research and Development Asset (IPR&D) called RES-529, which has a balance of $8.6 million at both September 30, 2018 and December 31, 2017. RES-529 is a PI3K/Akt/mTOR pathway inhibitor in preclinical development for oncology. There was no impairment to the Company’s RES-529 intangible asset recognized during the three or nine months ended September 30, 2018 or 2017.

 

6.	Convertible Preferred Stock, Common Stock and Common Stock Warrants

 

2018 Common Stock Offering

 

In January 2018, the Company entered into an Underwriting Agreement (the “Agreement”) pursuant to which it issued 15,000,000 shares of Common Stock and warrants to purchase 15,000,000 shares of Common Stock with an initial exercise price of $0.80 per share for cash proceeds of $10.8 million. In addition, as compensation for its services, the Company granted to the underwriter in the transaction an option (the “Over-Allotment Option”) to purchase, in the aggregate, 2,250,000 shares of Common Stock (the “Option Shares”) and warrants to purchase up to 2,250,000 shares of Common Stock (the “Option Warrants”). The underwriter exercised its right to purchase a portion of the Option Warrants and received an additional 1,970,625 warrants to purchase Common Stock with an initial exercise price $0.80 per share.

 

 In addition, at the closing, the Company issued to designees of the underwriter warrants to purchase up to 750,000 shares of Common Stock. The underwriter’s warrants have an exercise price of $1.00 per share, a term of five years from the date of issuance and otherwise substantially similar terms to the form of the investor warrant.

 

During its evaluation of equity classification for the Common Stock warrants, the Company considered the conditions as prescribed within ASC 815-40, Derivatives and Hedging, Contracts in an Entity’s own Equity (“ASC 815-40”). The conditions within ASC 815-40 are not subject to a probability assessment. The warrants do not fall under the liability criteria within ASC 480 Distinguishing Liabilities from Equity as they are not puttable and do not represent an instrument that has a redeemable underlying security. The warrants do meet the definition of a derivative instrument under ASC 815, but are eligible for the scope exception as they are indexed to the Company’s own stock and would be classified in permanent equity if freestanding.

 

As a result of the Company's Common Stock offering in January 2018, all outstanding shares of the Company's Series A convertible preferred stock converted into 21,006,918 shares of Common Stock of which (i) 8,306,278 shares were issued for the automatic conversion of Series A convertible preferred stock (ii) 1,032,219 shares were issued upon settlement of accrued dividends and (iii) 11,668,421 shares were issued for the settlement of the “make-whole” adjustment feature. A deemed dividend of $8.2 million was recognized for the value of the common shares issued for the settlement of the make-whole adjustment feature.

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Common Stock Warrants

 

As of September 30, 2018, the Company had the following warrants outstanding to acquire shares of its common stock:

 

 

During the nine months ended September 30, 2018, 421,221 warrants expired and no warrants were exercised.

 

7.	Stock-Based Compensation

 

2015 Equity Plan

 

The Diffusion Pharmaceuticals Inc. 2015 Equity Plan, as amended (the "2015 Equity Plan"), provides for increases to the number of shares reserved for issuance thereunder each January 1, equal to 4.0% of the total shares of the Company’s common stock outstanding as of the immediately preceding December 31, unless a lesser amount is stipulated by the Compensation Committee of the Company's Board of Directors. Accordingly, 580,785 shares were added to the reserve as of January 1, 2018, which shares may be issued in connection with the grant of stock-based awards, including stock options, restricted stock, restricted stock units, stock appreciation rights and other types of awards as deemed appropriate, in each case, in accordance with the terms of the 2015 Equity Plan. As of September 30, 2018, there were 27,268 shares of common stock available for future issuance under the 2015 Equity Plan.

 

The Company recorded stock-based compensation expense in the following expense categories of its unaudited interim condensed consolidated statements of operations for the periods indicated:

 

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

The following table summarizes the activity related to all stock option grants to employees and non-employees for the nine months ended September 30, 2018:

 

 

Non-employee Stock Options

 

Non-employee stock options are remeasured to fair value each period using a Black-Scholes option-pricing model until the options vest. The Company did not grant any stock options to non-employees during the nine months ended September 30, 2018. The total fair value of non-employee stock options vested during the three months ended September 30, 2018 and 2017 was approximately $1,000 and $7,000, respectively. The total fair value of non-employee stock options vested during the nine months ended September 30, 2018 and 2017 was approximately $3,000 and $83,000, respectively. At September 30, 2018, there were 5,166 unvested options subject to remeasurement and approximately $2,000 of unrecognized compensation expense that will be recognized over a weighted-average period of 1.26 years.

 

Employee Stock Options

 

During the nine months ended September 30, 2018, the Company granted 660,000 stock options to employees. The weighted average grant date fair value of stock option awards granted to employees was $0.86 during the nine months ended September 30, 2018. During the three months ended September 30, 2018 and 2017 the Company recognized stock-based compensation expense of $0.3 million and $0.3 million, respectively. During the nine months ended September 30, 2018 and 2017, the Company recognized stock-based compensation expense of $1.0 million and $0.9 million, respectively. No options were exercised during any of the periods presented. At September 30, 2018, there was $2.1 million of unrecognized compensation expense that will be recognized over a weighted-average period of 5.2 years.

 

Options granted were valued using the Black-Scholes option-pricing model and the weighted average assumptions used to value the options granted during the nine months ended September 30, 2018 and 2017 were as follows:

 

 

 

DIFFUSION PHARMACEUTICALS INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

Restricted Stock Awards

 

As of September 30, 2018, there were no unvested shares of restricted stock. During the nine months ended September 30, 2018 and 2017, there were 3,066 and 4,599 shares that vested, respectively and the Company recognized stock-based compensation expense of approximately $6,000 and $9,000, respectively.

 

8.	Commitments and Contingencies

 

Office Space Rental

 

The Company leases office and laboratory facilities in Charlottesville, Virginia. Rent expense related to the Company's operating lease for the three months ended September 30, 2018 and 2017 was approximately $28,000 and $28,000, respectively. Rent expense for the nine months ended September 30, 2018 and 2017 was approximately $84,000 and $80,000, respectively. The Company will continue to recognize rent expense on a straight-line basis over the lease period and will accrue for rent expense incurred but not yet paid. Future minimum rental payments under the Company's non-cancelable operating lease at September 30, 2018 was as follows:

 

 

Arrangement with Clinical Research Organization

 

On July 5, 2017, the Company entered into a Master Services Agreement ("MSA") with a contract research organization ("CRO") to provide clinical trial services for individual studies and projects by executing individual work orders. The MSA and associated work orders are designed such that payments are to be made in advance of the work to be performed.  The Company recognized research and development expenses related to this MSA of $0.4 million and $1.6 million during the three and nine months ended September 30, 2018. As of September 30, 2018, there was $0.3 million of prepaid research and development costs that are estimated to be recognized during 2018.

 

Legal Proceedings

 

On August 7, 2014, a complaint was filed in the Superior Court of Los Angeles County, California by Paul Feller, the Company’s former Chief Executive Officer under the caption Paul Feller v. RestorGenex Corporation, Pro Sports & Entertainment, Inc., ProElite, Inc. and Stratus Media Group, GmbH (Case No. BC553996). The complaint asserts various causes of action, including, among other things, promissory fraud, negligent misrepresentation, breach of contract, breach of employment agreement, breach of the covenant of good faith and fair dealing, violations of the California Labor Code and common counts. The plaintiff is seeking, among other things, compensatory damages in an undetermined amount, punitive damages, accrued interest and an award of attorneys’ fees and costs. On December 30, 2014, the Company filed a petition to compel arbitration and a motion to stay the action. On April 1, 2015, the plaintiff filed a petition in opposition to the Company’s petition to compel arbitration and a motion to stay the action. After a hearing for the petition and motion on April 14, 2015, the Court granted the Company’s petition to compel arbitration and a motion to stay the action. On January 8, 2016, the plaintiff filed an arbitration demand with the American Arbitration Association. No arbitration hearing has yet been scheduled. A dismissal hearing is scheduled for November 19, 2018. The Company believes this matter is without merit and intends to defend the arbitration vigorously. Because this matter is in an early stage, the Company is unable to predict its outcome and the possible loss or range of loss, if any, associated with its resolution or any potential effect the matter may have on the Company’s financial position. Depending on the outcome or resolution of this matter, it could have a material effect on the Company’s financial position.

 

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