Natera, Inc. - Quarter Report: 2015 September (Form 10-Q)

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

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FORM 10-Q

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(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, 2015

OR

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

For the transition period from                       to                      

Commission file number: 001-37478

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NATERA, INC.

(Exact Name of Registrant as Specified in Its Charter)

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(650) 249‑9090

(Registrant’s Telephone Number, Including Area Code)

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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, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

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

As of October 30, 2015, the number of outstanding shares of the registrant’s common stock, par value $0.0001 per share, was 49,996,087. 

 

 

 

Natera, Inc.

FORM 10-Q FOR THE QUARTER ENDED SEPTEMBER 30, 2015

TABLE OF CONTENTS

 

 

 

SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This report contains forward-looking statements. The forward-looking statements are contained principally in the sections titled “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” but are also contained elsewhere in this report. Forward-looking statements include information concerning our future results of operations and financial position, strategy and plans, and our expectations for future operations. Forward-looking statements include all statements that are not historical facts and, in some cases, can be identified by terms such as "believe," "may," "will," "estimate," "continue," "anticipate," "design," "intend," "expect," "could," "plan," "potential," "predict," "seek," "should," "would" or the negative version of these words and similar expressions.

Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause our actual results, performance or achievements to be materially different from any future results, performance or achievements expressed or implied by the forward-looking statements, including those described in "Risk Factors" and elsewhere in this report. Given these uncertainties, you should not place undue reliance on these forward-looking statements. Also, forward-looking statements represent our beliefs and assumptions only as of the date of this report. In light of the significant uncertainties in these forward-looking statements, you should not regard these statements as a representation or warranty by us or any other person that we will achieve our objectives and plans in any specified time frame, or at all. You should read this report completely and with the understanding that our actual future results may be materially different from what we expect

These forward-looking statements include, but are not limited to, statements concerning the following:

 

Any forward-looking statement made by us in this report speaks only as of the date on which it is made. Except as required by law, we disclaim any obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in these forward-looking statements, even if new information becomes available in the future.

 

 

 

 

PART I – FINANCIAL INFORMATION

 

ITEM 1.FINANCIAL STATEMENTS

Natera, Inc.

Condensed Consolidated Balance Sheets

(Unaudited)

(In thousands, except per share data)

 

See accompanying notes to the unaudited condensed consolidated financial statements.

Natera, Inc.

Condensed Consolidated Statements of Operations

(Unaudited)

(In thousands, except per share data)

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

Natera, Inc.

Condensed Consolidated Statements of Cash Flows

(Unaudited)

(In thousands)

 

See accompanying notes to the unaudited condensed consolidated financial statements.

 

 

Natera, Inc.

 

Notes to Unaudited Interim Condensed Consolidated Financial Statements

 

1. Description of Business

Natera, Inc. (the "Company") was formed in the state of California as Gene Security Network, LLC in November 2003 and incorporated in the state of Delaware in January 2007. The Company’s mission is to change the management of genetic disease worldwide. The Company operates a laboratory certified under the Clinical Laboratory Improvement Amendments ("CLIA") providing a host of preconception and prenatal genetic testing services. The Company operates in one segment and has a subsidiary that operates in the state of Texas.

The Company's product offerings include its Panorama Non-Invasive Prenatal Test ("NIPT") that screens for chromosomal abnormalities of a fetus typically with a blood draw from the mother; Horizon Carrier Screening ("Horizon") to determine carrier status for a large number of severe genetic diseases that could be passed on to the carrier’s children; Spectrum Pre-implantation Genetic Screening ("PGS") and Spectrum Pre-implantation Genetic Diagnosis ("PGD") to analyze chromosomal anomalies or inherited genetic conditions during an in vitro fertilization ("IVF") cycle to select embryos with the highest probability of becoming healthy children; Anora Products of Conception ("POC") test to rapidly and extensively analyze fetal chromosomes to understand the cause of miscarriage; Non-Invasive Paternity Testing ("PAT"), to determine paternity by analyzing the fragments of fetal deoxyribonucleic acid ("DNA") in a pregnant mother's blood and a blood sample from the alleged father(s), which is marketed and sold exclusively by a partner from whom the Company receives a royalty. All testing is available principally in the United States and Europe. The Company also offers Constellation, a cloud-based software product that allows laboratory customers to gain access through the cloud to the Company’s algorithms and bioinformatics in order to validate and launch tests based on the Company’s technology.

Reverse Stock Split

The Company's board of directors and stockholders approved a 1-for-1.63 reverse split of its capital stock, which was effected on June 19, 2015. All references to common stock, options to purchase common stock, restricted stock, share data, per share data, warrants, convertible preferred stock and related information have been retroactively adjusted where applicable in this report to reflect the reverse stock split of the Company's capital stock as if it had occurred at the beginning of the earliest period presented.

Initial Public Offering

In July 2015, the Company completed an initial public offering (“IPO”), and subsequently in August 2015, the Company completed the sale of additional shares upon exercise of the underwriters’ over-allotment option. In connection with the IPO, including the over-allotment option, the Company sold 10,900,000 shares of common stock at $18.00 per share, which raised $178.5 million in proceeds, net of underwriting discounts and commissions and offering expenses.

 

2. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited interim condensed consolidated financial statements have been prepared in conformity with U.S. generally accepted accounting principles (“U.S. GAAP”) for interim financial information. In the opinion of management, the unaudited interim condensed consolidated financial information includes only adjustments of a normal recurring nature necessary for a fair presentation of the results of operations, financial position, changes in stockholders’ deficit, and cash flows. The results of operations for the three and nine months ended September 30, 2015, are not necessarily indicative of the results for the full year or the results for any future periods. The condensed consolidated balance sheet as of December 31, 2014 has been derived from audited financial statements at that date, these financial statements should be read in conjunction with the audited financial statements, and related notes for the year ended December 31, 2014 included in the prospectus dated July 1, 2015 that forms a part of the Company’s Registration

Statement on Form S-1, filed with the SEC pursuant to Rule 424 promulgated under the Securities Act of 1933, as amended.

Principles of Consolidation

The accompanying condensed consolidated financial statements include all the accounts of the Company and its subsidiary. The Company established a subsidiary that operates in the state of Texas in December 2014 to support the Company’s laboratory and operational functions, which became active in the second quarter of 2015. All intercompany balances and transactions have been eliminated.

Use of Estimates

The preparation of financial statements in accordance with U.S. GAAP requires management to make estimates and assumptions about future events that affect the amounts of assets and liabilities reported, disclosures about contingent assets and liabilities, and reported amounts of revenues and expenses. Significant items subject to such estimates include the allowance for doubtful accounts, stock-based compensation, the fair value of common stock and fair value of debt accounted for under ASC 815, as well as income tax uncertainties. These estimates and assumptions are based on management's best estimates and judgment. Management regularly evaluates its estimates and assumptions using historical experience and other factors; however, actual results could differ from these estimates and could have an adverse effect on the Company's financial statements. 

Fair Value

The Company discloses the fair value of financial instruments for financial assets and liabilities for which the value is practicable to estimate. Fair value is defined as the price that would be received upon the sale of an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). The Company carried senior secured term loan and warrants at fair value according to the fair value measurement guidance.

Cash and Cash Equivalents

Cash and cash equivalents consist of cash and money market deposits with financial institutions.

Investments

Management determines the appropriate classification of securities at the time of purchase and reevaluates such determination at each balance sheet date. The Company generally classifies its entire investment portfolio as available-for-sale. The Company views its available-for-sale portfolio as available for use in current operations. Accordingly, the Company classifies all investments as short-term, even though the stated maturity may be more than one year from the current balance sheet date. Available-for-sale securities are carried at fair value, with unrealized gains and losses reported in accumulated other comprehensive income (loss), which is a separate component of stockholders’ equity (deficit).

Risk and Uncertainties

Financial instruments that potentially subject the Company to credit risk consist of cash and accounts receivable. The Company limits its exposure to credit loss by placing its cash in financial institutions with high credit ratings. The Company's cash may consist of deposits held with banks that may at times exceed federally insured limits. The Company performs evaluations of the relative credit standing of these financial institutions and limits the amount of credit exposure with any one institution.

The Company bills third-party payers for certain tests performed. The amount that is ultimately received from the payer for our claim and the timing of such payments are subject to the determination of the payer based on the nature of the test performed and their view of our business practices with respect to collections of plan deductibles and co-

payments from patients and other activities. This determination can impact both the amount and timing of when our invoices are collected. Payers may also withhold payments and request refunds of prior payments if we do not perform in accordance with the policies of these payers.

The Company performs evaluations of financial conditions for clinics and laboratory partners and generally does not require collateral to support credit sales. Sales to Quest represented 10% and 13% of total revenue for the three and nine months ended September 30, 2014, respectively. For the three and nine months ended September 30, 2015, there were no customers exceeding 10% of total revenues on an individual basis. As of September 30, 2015, one customer had a receivable balance of approximately 12% of net accounts receivable, and as of December 31, 2014 there were no customers who had a balance greater than 10%.

Revenue Recognition

The Company generally bills an insurance carrier, a clinic or a patient for the test upon delivery of the test result. The Company also bills patients directly for out-of-pocket costs not covered by their insurance carriers representing co-pays and deductibles in accordance with their insurance carrier and health plans. The Company may not get reimbursed for tests completed if the tests are not covered under the insurance carrier’s reimbursement policies or the Company is not a qualified provider to the insurance carrier. For tests performed, where an agreed upon reimbursement rate or fixed fee and a predictable history or likelihood of collections exists, the Company recognizes revenues upon delivery of the test report to the prescribing physician based on the established billing rate less contractual and other adjustments, such as an allowance for doubtful accounts, to arrive at the amount that the Company expects to collect. In all other situations, as the Company does not have a sufficient history of collection and is not able to determine collectability, the Company recognizes revenues when cash is received. From time to time, we receive requests for refunds of payments previously made by insurance carriers. The Company has established an accrued liability for potential refund requests based on our experience.

In cases where the Company sells its tests through its laboratory partners, the majority of the laboratory partners bill the patient, clinic, or insurance carrier for the performance of the Company's tests.

For tests sold through a limited number of its laboratory partners, the Company bills directly to a patient, clinic or insurance carrier, or a combination of the insurance carrier and patient for the fees. The Company considers its services rendered when it delivers reports of its test results to the laboratory partner, clinic or patient. When the Company has contracted fixed rates for its services and collectability of its revenues is reasonably assured, it recognizes revenues upon delivery of test reports. The fixed fees identified in contracts with laboratory partners change only if a pricing amendment is agreed upon between both parties. For cases in which there is no fixed price established with a laboratory partner, the Company then recognizes revenues from partner distributed tests on a cash basis.

Certain of the Company's arrangements include multiple deliverables. For revenue arrangements with multiple deliverables, the Company evaluates each deliverable to determine whether it qualifies as a separate unit of accounting. This determination is based on whether the deliverable has "stand-alone value" to the customer and whether a general right of return exists. The consideration that is fixed or determinable is then allocated to each separate unit of accounting based on the relative selling price of each deliverable. The consideration allocated to each unit of accounting is recognized as the related goods or services are delivered, limited to the consideration that is not contingent upon future deliverables. The Company uses judgment in identifying the deliverables in its arrangements, assessing whether each deliverable is a separate unit of accounting, and in determining the best estimate of selling price for certain deliverables. The Company also uses judgment in determining the period over which the deliverables are recognized in certain of its arrangements. Any amounts received that do not meet the criteria for revenue recognition are recorded as deferred revenue until such criteria are met.

The Company receives royalty revenue through the licensing and the provisioning of services to support the use of the Company's proprietary technology with its customer. Royalty revenues are recognized when earned under the terms of the related agreements and are included in Other Revenues in the statements of operations.

Stock‑Based Compensation

Stock‑based compensation related to stock options granted to the Company’s employees is measured at the grant date based on the fair value of the award. The fair value is recognized as expense over the requisite service period, which is generally the vesting period of the respective awards. No compensation cost is recognized on stock options for employees who do not render the requisite service and therefore forfeit their rights to the stock options. The Company uses the Black‑Scholes option‑pricing model to estimate the fair value of its stock options.

The Company accounts for stock options issued to non-employees based on the estimated fair value of the awards using the Black-Scholes option-pricing model. The measurement of stock-based compensation is subject to periodic adjustments as the underlying equity instruments vest, and the resulting change in value, if any, is recognized in the Company's statements of operations during the period that the related services are rendered.

The Black-Scholes option-pricing model requires the input of the Company's expected stock price volatility, the expected life of the awards, a risk-free interest rate, and expected dividends. Determining these assumptions requires significant judgment. The expected term was based on the simplified method and where the Company did not qualify to use the simplified method, the Company used the lattice model, and the volatility rate was based on that of publicly traded companies in the DNA sequencing, diagnostics, or personalized medicine industries. When selecting the public companies in these industries to be used in the volatility calculation, companies were selected with comparable characteristics to the Company, including enterprise value and financial leverage. Companies were also selected with historical share price volatility sufficient to meet the expected life of the Company's stock options. The historical volatility data was computed using the daily closing prices for the selected companies' shares during the equivalent period of the calculated expected term of the Company's stock options. The expected life of the non-employee option grants was based on their remaining contractual life at the measurement date. The risk-free interest rate assumption was based on U.S. Treasury instruments with maturities that were consistent with the option's expected life. The expected dividend assumption was based on the Company's history and expectation of dividend payouts.

Warrants

The Company accounts for warrants to purchase shares of its common stock as a liability at fair value on the balance sheet date because the Company may be obligated to redeem these warrants at some point in the future. The warrants are subject to remeasurement at each balance sheet date, with changes in fair value recognized as a gain or loss from the changes in fair value of the warrants in the statements of operations. The Company will continue to adjust the liability for changes in fair value until such time that the warrants are converted or expire.

 Net (Loss) Earnings per Share

Basic net income (loss) per share attributable to common stockholders is calculated by dividing the net income (loss) attributable to common stockholders by the weighted-average number of shares of common stock outstanding for the period. Prior to the Company’s IPO of its common stock, the Company’s convertible preferred stock was entitled to receive dividends, prior and in preference to any declaration or payment of any dividend on common stock and thereafter participate pro rata on an as converted basis with the common stock holders on any distributions to common stockholders. The convertible preferred shares were therefore considered to be participating securities. As a result, the Company calculated the net income (loss) per share using the two-class method. Accordingly, the net income (loss) attributable to common stockholders is derived from the net income (loss) for the period and, in periods in which the Company has net income attributable to common stockholders, an adjustment is made for the noncumulative dividends and allocations of earnings to participating securities based on their outstanding shareholder rights. Under the two-class method, the net loss attributable to common stockholders is not allocated to the convertible preferred stock as the convertible preferred stock did not have a contractual obligation to share in the Company’s losses. The diluted net income per share attributable to common stockholders is computed by giving effect to all potential dilutive common stock equivalents outstanding for the period. In periods when the Company has incurred a net loss, convertible preferred stock, options to purchase common stock and common stock warrants and common stock subject to repurchase are considered common stock equivalents but

have been excluded from the calculation of diluted net loss per share attributable to common stockholders as their effect is antidilutive.

 

Property and Equipment

Property and equipment, including purchased and internally developed software, are stated at cost. Depreciation is calculated using the straight-line method over the estimated useful lives of the assets, which are generally three years. Leasehold improvements are amortized using the straight-line method over the estimated useful lives of the assets or the remaining term of the lease, whichever is shorter. The Company periodically reviews the depreciable lives assigned to property and equipment placed in service and change the estimates of useful lives to reflect the results of such reviews. During the six months ended September 30, 2015, the Company increased the depreciable lives of certain sequencing and automation machinery equipment from three years to five years. The effect of this change in estimate for each of the three and nine months ended September 30, 2015 was a decrease in loss from operations and net loss of $0.6 million and $1.2 million respectively. The effect of this change in estimate was a decrease in net basic and diluted loss per share of $0.01 for the three months ended September 30, 2015 and $0.07 for the nine months ended September 30, 2015.

Recent Accounting Pronouncements

From time to time, new accounting pronouncements are issued by the FASB or other standard setting bodies and adopted by the Company as of the specified effective date. Unless otherwise discussed below, the Company believes that the impact of recently issued standards that are not yet effective will not have a material impact on its financial position or results of operations upon adoption.

In August 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014‑15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern (ASU 2014‑15). ASU 2014‑15 requires management to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. In doing so, companies will have reduced diversity in the timing and content of footnote disclosures compared to footnote disclosures under today’s guidance. ASU 2014‑15 is effective for the Company in the first quarter of 2016 with early adoption permitted. The Company does not believe the impact of adopting ASU 2014‑15 on its financial statements will be significant.

In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update No. 2014‑09, Revenue from Contracts with Customers (ASU 2014‑09) to provide guidance on revenue recognition. ASU 2014‑09 requires a company to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under today’s guidance. These may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. In August 2015, FASB issued ASU 2015-14, which defers the effective date of ASU 2014-09 for all entities by one year. The guidance is effective for the Company in the first quarter of 2018.  ASU 2014-09, as amended by ASU 2015-14, is effective for interim or annual periods beginning after December 15, 2017. Early adoption up to the first quarter of 2017 is permitted. Upon adoption, ASU 2014‑09 can be applied retrospectively to all periods presented or only to the most current period presented with the cumulative effect of changes reflected in the opening balance of retained earnings in the most current period presented. The Company is currently evaluating the impact of adopting ASU 2014‑09 on its financial statements.

In April 2015, the Financial Accounting Standards Board issued Accounting Standards Update No. 2015‑03, Interest—Imputation of Interest (Subtopic 835‑30): Simplifying the Presentation of Debt Issuance Costs (ASU 2015‑03). ASU 2015‑03 requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. ASU 2015‑03 is effective for the Company in the first quarter of 2016 with early adoption permitted. The Company does not believe the impact of adopting ASU 2015‑03 on its financial statements will be significant.

In April 2015, the Financial Accounting Standards Board issued Accounting Standards Update No. 2015‑05, Intangibles—Goodwill and Other—Internal‑Use Software (Subtopic 350‑40): Customer’s Accounting for Fees Paid in a

Cloud Computing Arrangement (ASU 2015‑05). ASU 2015‑05 provides guidance to clarify the customer’s accounting for fees paid in a cloud computing arrangement. ASU 2015‑05 is effective for the Company in the first quarter of 2016 with early adoption permitted. The Company is currently evaluating the impact of adopting ASU 2015‑05 on its financial statements.

In July 2015, the Financial Accounting Standards Board issued Accounting Standards Update No. 2015-11, Inventory (Topic 330): Simplifying the Measurement of Inventory (ASU 2015-11). ASU 2015-11 simplifies the subsequent measurement of inventory by replacing today’s lower of cost or market test with a lower of cost and net realizable value test. The guidance applies only to inventories for which cost is determined by methods other than last-in first-out (LIFO) and the retail inventory method (RIM). Entities that use LIFO or RIM will continue to use existing impairment models (e.g., entities using LIFO would apply the lower of cost or market test). The guidance is effective for public business entities for fiscal years beginning after December 15, 2016, and interim periods within those fiscal years. For all other entities, it is effective for fiscal years beginning after December 15, 2016, and interim periods within fiscal years beginning after December 15, 2017. The Company is currently evaluating the impact of adopting ASU 2015‑11 on its financial statements.

3. Fair Value Measurements

The Company's financial assets and liabilities carried at fair value are comprised of investment assets that include money market and investments, a liability for convertible preferred stock warrants, a liability for common stock warrants and a senior secured term loan. The Company’s Equipment Financing Facility, described in Note 8, is not measured at fair value on a recurring basis and is carried at amortized cost. The Company believes the fair value of the facility approximates its carrying value, or amortized cost, due to the short-term nature of this obligation and the interest rate relative to current market rates.

The fair value accounting guidance requires that assets and liabilities be carried at fair value and classified in one of the following three categories:

Level I: Quoted prices in active markets for identical assets and liabilities that the Company has the ability to access

Level II: Observable market‑based inputs or unobservable inputs that are corroborated by market data, such as quoted prices, interest rates, and yield curves

Level III: Inputs that are unobservable data points that are not corroborated by market data.

This hierarchy requires the Company to use observable market data, when available, and to minimize the use of unobservable inputs when determining fair value.

Assets and Liabilities That Are Measured at Fair Value on a Recurring Basis

The following table represents the fair value hierarchy for the Company’s financial assets and financial liabilities measured at fair value on a recurring basis:

 

The Company's convertible preferred and common stock warrants are valued using Level III inputs; the Company uses inputs from a Black-Scholes model with market volatility that is determined for comparable companies in the same business sector. As of September 30, 2015, the Company’s third-party valuation specialist uses the common stock price as quoted on the NASDAQ stock market. The carrying amounts of cash, accounts receivable, and accounts payable approximate their fair value and are excluded from the table above.

In April 2013, the Company entered into a senior secured term loan with a third‑party lender, which consists of a credit agreement, royalty agreement, warrants, and loan commitment. The Company considered the guidance under ASC 825‑10, Financial Instruments, which provides a measurement basis election for most financial instruments (i.e., either historical cost or fair value), allowing reporting entities to mitigate potential mismatches that arise under the current mixed measurement attribute model and ASC 820, Fair Value Measurements and Disclosures that provides for the fair value measurement of assets and liabilities, except for derivatives, for which the fair value is determined by ASC 815, Derivatives and Hedging.

The Company evaluated the components of the senior secured term loan and determined that they are derivatives to be evaluated under ASC 815‑15‑25‑1. The fair value accounting for derivatives is not an option, as derivatives must be fair valued under ASC 815 following the measurement guidance under ASC 820. Therefore, the Company engaged a third party to determine the fair value of the derivatives using the guidance of ASC 820 and recorded the Senior Secured Term Loan at fair value.

ASC 815 requires the terms and features of an instrument that are not a derivative itself to be evaluated for embedded derivatives that must be bifurcated and separately accounted for as freestanding derivatives. In general, under ASC 815‑15‑25‑1, an embedded derivative is separated from the host contract and accounted for as a derivative instrument if and only if the following criteria are met:

Based upon the Company's evaluation, the senior secured term loan constitutes a liability with embedded derivative features that must be accounted for separately as mark-to-market instruments. In addition, adjustments to the embedded royalty feature will be recorded as interest expense as they occur, offset to the carrying amount of the debt (with the eventual cash outlay to settle such amounts recorded against the carrying amount of the debt). Based on the Company's evaluation, it was determined that the warrants granted are detachable and therefore are a stand-alone component of the senior secured term loan to be fair valued using Level III inputs as a separate derivative. Additionally, it was determined that the remaining components are embedded derivatives of the senior secured term loan, which require a fair value assessment using Level III inputs at the end of each reporting period. The Company's independent appraiser assisted in the evaluation of the components of the senior secured term loan that require significant judgment or estimation. The fair value of the components is calculated using various techniques such as (i) discounted future cash flows, (ii) the income approach, using various revenue assumptions and applying a Monte-Carlo simulation to each outcome and (iii) Black-Scholes Option Pricing Model with market volatility that is determined by comparison to comparable companies in the same business sector. The fair value of the senior secured term loan is re-measured at the end of each reporting period with the change in fair value recorded within non-operating expense in the statements of operations.

The following table provides a roll forward of the fair value, as determined by Level III inputs, of the warrants for the nine months ended September 30, 2015:

 

The following table provides a roll forward of the fair value, as determined by Level III inputs, of the senior secured term loan for the nine months ended September 30, 2015:

 

The following table presents quantitative information about the inputs and valuation methodologies used for the Company’s fair value measurement classified in Level III of the fair value hierarchy at September 30, 2015.

Senior Secured Term Loan

The fair value of the liability represents a term loan, royalty interest, and a loan commitment that is based upon the achievement of certain revenue targets over the life of the contract. The fair value of the liability is determined using discounted cash flow methodology, a Monte Carlo Simulation model for projected revenues, and the Longstaff-Schwartz model for royalty payments with significant inputs that include discount rate, projected revenues, projected royalty payments and percentage probability of occurrence for projected revenues and royalty payments. A significant change in projected revenues in isolation could result in a significantly different fair value measurement; a significant change in the discount rate in isolation could result in a significantly different fair value measurement; and changes in the probability of occurrence between the outcomes in isolation could result in a significantly different fair value measurement.

Warrants

The significant unobservable inputs used in the fair value of warrants are derived from the Company's common stock valuation that is based upon a model with inputs from a Black-Scholes model and market volatility that is determined for comparable companies in the same business sector. The inherent risk in the market volatility is the selection of companies with similar business attributes to the Company.

4. Financial Instruments

The Company elected to invest a portion of its cash assets in conservative, income earning, liquid investments effective September 2015. Cash equivalents and investments, all of which are classified as available-for-sale securities, consisted of the following:

 

The Company’s investments in U.S. Treasury securities and government sponsored entity securities have contractual maturities between one and five years from September 30, 2015.

 

5. Balance Sheet Components

Property and Equipment, net

The Company’s property and equipment consisted of the following:

In September 2015, the Company paid off its equipment loan, thus none of the Company's equipment is pledged under the Equipment Financing Facility.

The Company periodically evaluates the carrying value of long-lived assets when events or circumstances warrant such a review. The carrying value of a long-lived asset is considered impaired when the estimated realizable value of the asset is less than the carrying value of the asset.  In that event, a loss is recognized based on the amount by which the carrying value exceeds the fair value of the long-lived asset.  Fair value is determined based on the estimated realizable value of the long-lived asset.

The Company recorded an asset impairment charge of $0.6 million against a specific group of machinery and equipment during the three and nine months ended September 30, 2015. This specific group of machinery and equipment

is used to perform carrier screening testing which the Company currently outsources to our partners. The impairment charge was recorded to reflect reductions in the estimated realizable value of the machinery and equipment as a result of planning for its sale in the secondary market. The Company recorded the total impairment charge of $0.6 million in cost of product revenue.  The Company has classified the impaired machinery and equipment as held for sale at the estimated realizable value of $0.5 million.

Accrued Compensation

The Company’s accrued compensation consisted of the following:

Other Accrued Liabilities

The Company’s other accrued liabilities consisted of the following:

 

 

6. Commitments and Contingencies

Operating Leases

As of September 30, 2015, the Company sub‑leases office facilities under non‑cancelable operating lease agreements. In January 2013, the Company amended its sublease agreement to expand its corporate headquarters. In connection with the amendment, the  Company executed a letter of credit in favor of the lessors for $0.8 million, which is secured with a restricted cash account. The related subleases expire in October 2016.

On March 21, 2014, the Company entered into an additional sub‑lease agreement to expand its corporate headquarters for additional office and laboratory space. In connection with the sub-lease, the Company executed a letter of credit in April 2015 in favor of the lessors for $0.3 million, which is secured with a restricted cash account. The lease and additional sub‑lease expire in January 2017.

In April 2015, the Company entered into a sub-lease agreement for additional office space in Redwood City, California. The additional space carries a base rent of $62,700 per month. The lease period began in June 2015 and will terminate in August 2016. In addition, the Company has paid a security deposit of $125,500.

In September 2015, the Company’s subsidiary entered into a long-term lease agreement for lab and office space in Austin, Texas. The lease term is 132 months beginning in December 2015 with monthly payments beginning in

December 2016, increasing from $133,000 to $207,500. Per the terms of the lease, the subsidiary has paid a security deposit of $375,000, and the landlord has allotted the subsidiary a refundable allowance for leasehold improvements of up to $7.2 million.

In October 2015, the Company extended its corporate headquarters leases agreement through October 5, 2023 as further described in Note 16.

The future annual minimum lease payments under all non-cancelable operating leases as of September 30, 2015 are as follows:

Rent expense for the three months ended September 30, 2015 and 2014 was $0.7 million and $0.3 million, respectively. Rent expense for the nine months ended September 30, 2015 and 2014 was $1.8 million and $1.0 million, respectively. The Company is also required to pay its share of facility operating expenses with respect to the facilities in which it operates.

Legal Proceedings

From time to time, the Company is involved in disputes, litigation, and other legal actions. The Company is aggressively defending its current litigation matters, and while there can be no assurances and the outcome of these matters is currently not determinable, the Company currently believes that there are no existing claims or proceedings that are likely to have a material adverse effect on its financial position. There are many uncertainties associated with any litigation and these actions or other third-party claims against the Company may cause the Company to incur costly litigation and/or substantial settlement charges.

In addition, the resolution of any intellectual property litigation may require the Company to make royalty payments, which could adversely affect gross margins in future periods. If this were to occur, the Company's business, financial condition, results of operations, and cash flows could be adversely affected. The actual liability in any such matters may be materially different from the Company's estimates, if any, which could result in the need to record or adjust a liability and record additional expenses. During the periods presented, the Company has not recorded any accrual for loss contingencies associated with such legal proceedings, determined that an unfavorable outcome is probable or reasonably possible, or determined that the amount or range of any possible loss is reasonably estimable.

On January 6, 2012, the Company filed a declaratory judgment action in the U.S. District Court for the Northern District of California, alleging that U.S. Patent No. 6,258,540 licensed by Sequenom, Inc. ("Sequenom") from Isis Innovation Limited, Inc. ("Isis") (the '540 patent), is invalid, unenforceable and not infringed by the Company. The '540 patent relates to non-invasive prenatal diagnosis methods. This case was consolidated in the Northern District of California with a case that Sequenom, an affiliate of Sequenom, and Isis brought on January 24, 2012 in the Southern District of California alleging infringement by the Company and DNA Diagnostics Center, Inc., the Company's distribution partner of its non-invasive paternity test, of certain claims of the '540 patent. Ariosa Diagnostics, Inc. ("Ariosa") and Verinata Health, Inc. ("Verinata"), now a division of Illumina, Inc. also filed declaratory judgment actions regarding the '540 patent against Sequenom in the Northern District. Sequenom asserted counterclaims of infringement of the '540 patent against both Ariosa and Verinata in those respective cases. All of these cases were designated related cases. On October 30, 2013,

the District Court issued an order granting Ariosa's motion for summary judgment in its case against Sequenom, finding that the claims asserted against Ariosa are invalid under 35 U.S.C. §101 for reciting non-patentable subject matter. Many of the claims of the '540 patent asserted against the Company were invalidated by this order. Subsequently, Sequenom entered into stipulations with Verinata and the Company conditionally agreeing that the remaining asserted claims of the '540 Patent should be deemed invalid under 35 U.S.C. §101. The Court then entered judgment in favor of Verinata and the Company in their respective cases in November 2013. Sequenom has appealed all three judgments to the Court of Appeals for the Federal Circuit ("CAFC"). The CAFC has consolidated the Ariosa, Verinata and the Company's cases for purposes of appeal, such that the CAFC can make a single ruling on the '540 patent claims that apply to all parties involved. The appellate arguments were heard on November 7, 2014. On December 2, 2014, Sequenom and Verinata settled the pending claims between them. On June 12, 2015, the CAFC affirmed the district court's finding of invalidity with respect to us and Ariosa.  On August 13, 2015, Sequenom requested a rehearing en banc by the full panel of the CAFC , which has been supported by various amicus curiae briefs, and on October 19, 2015, the Company and Ariosa each filed a response to Sequenom’s request. The Company intends to continue to vigorously assert its claims and defend against the counterclaims in this lawsuit, but it cannot be certain of the outcome.

On April 22, 2011, a former employee filed an action in the U.S. District Court for the Northern District of California alleging that the Company made false statements to the government in connection with tracking of employee time and expenditures in connection with certain grants it received from the National Institutes of Health. After investigating the former employee's claims, the U.S. Attorney's Office for the Northern District of California filed a Notice of Election to Decline Intervention in this matter. The Company filed counterclaims against its former employee, alleging fraud in the inducement, breach of contract, and violation of the Computer Fraud and Abuse Act. The case proceeded to trial beginning on January 20, 2015 and on February 4, 2015, the jury returned a verdict in the Company’s favor on the plaintiff’s claims and in favor of the plaintiff on its counterclaim. The plaintiff's motion for a new trial was denied, and judgment was entered in favor of the Company on the plaintiff's claims and in favor of the plaintiff on the Company's counterclaim. The time for filing a notice of appeal has expired. The Company does not expect any further activity on this matter.

Third-Party Payer Reimbursement Audits

In November 2014, a third-party payer sought information as part of an investigative audit of claims which it had paid for certain genetic testing. The Company complied with their request and provided responsive information. In a letter dated June 2, 2015, the third-party payer alleged that it had overpaid $1.88 million to the Company,  which it claimed was an overpayment reflecting the difference between what it paid to the Company and what it contended it should have paid based on its fee schedule and coverage determinations.  In August 2015, the Company reached an agreement for a settlement payment of $1.18 million as part of a complete settlement of this matter. This charge was recorded against “revenue” in the second quarter of 2015 and “other accrued liabilities” as of June 30, 2015.

Contractual Commitment

As of September 30, 2015, the Company has non‑cancelable contractual commitments with a supplier for approximately $6.8 million and other material supplier commitments for approximately $6.4 million in the aggregate for inventory material used in the laboratory testing process. 

In January 2015, the Company entered into a laboratory services agreement with a total contractual commitment for a period of 18 months to purchase tests for a minimum of approximately $5.3 million.

In March 2015, the Company entered into an agreement with a major manufacturer to develop a version of the Panorama test for use in a specific country, including the right for the manufacturer to market and perform such test. Under the terms of the contract the Company will share up to half of the $13.5 million of the development and approval process costs as incurred. Further any other costs will be shared between the manufacturer and the Company equally. The reimbursement of the costs incurred by both partners under this agreement will be performed on a quarterly basis. As of September 30, 2015 the Company has not incurred any expenses in regards to this agreement.

7. Stock‑Based Compensation

2007 and 2015 Stock Plans

In January 2007, the Board of Directors (the Board) adopted, and the Company’s stockholders approved, the Company’s 2007 Stock Plan (the 2007 Plan), which was amended and restated on March 25, 2010 and amended on April 16, 2015. Pursuant to the 2007 Plan, stock options may be granted to employees, consultants, and outside directors of the Company. Options granted may be either incentive stock options or non-statutory stock options. Under the amended and restated 2007 Plan, the Company had reserved 15,999,289 shares of its common stock for issuance through September 30, 2015. The 2007 Plan was terminated in July 2015; however, the terms of the 2007 Plan will continue to govern any outstanding awards thereunder.

In June 2015, the Board adopted, and the Company’s stockholders approved, the Company’s 2015 Equity Incentive Plan (the 2015 Plan), which, by its terms, took effect as of the Company’s IPO. The Company reserved 3,451,495 shares of its common stock for issuance under the 2015 Plan; in addition, the Board and stockholders authorized the reservation of up to 9,890,310 shares of common stock to cover shares reserved but unissued under the 2007 Plan and shares subject to outstanding awards under the 2007 Plan that expire or lapse unexercised or shares issued under the 2007 Plan that are subsequently reacquired by the Company.

Early Exercise of Employee Options

Stock options granted under the 2007 Plan provide employee option holders the right to exercise unvested options in exchange for common stock. As of September 30, 2015, the Company had approximately 1.4 million exercised and unvested shares outstanding that are subject to a repurchase right held by the Company at the original issuance price in the event that the optionee’s employment is terminated, either voluntarily or involuntarily. Effective in the three months ended September 30, 2015, pursuant to the agreements with the option holders, the Company changed its estimated expiration of the Company’s repurchase right for 1.4 million exercised and unvested shares outstanding that are subject to repurchase right held by the Company through the 210 days after the date of the prospectus filed in connection with the Company’s IPO. Accordingly the unrecognized compensation expense is being accelerated over a shorter performance period through January 2016. As a result of this acceleration, the Company recorded an additional $0.6 million in stock based compensation expense during the three months ended September 30, 2015.

 

Stock Options

The following table summarizes option activity for the nine months ended September 30, 2015:

Stock‑Based Compensation Expense

Employee and non‑employee stock‑based compensation expense was calculated based on awards ultimately expected to vest and have been reduced for estimated forfeitures. Forfeitures are estimated at the time of grant and revised, if necessary, in subsequent periods, if actual forfeitures differ from those estimates.

The following table presents the effect of employee and non‑employee stock‑based compensation expense on selected statements of operations line items for the three and nine months ended September 30, 2015 and 2014.

 

 

As of September 30, 2015, approximately $15.5 million of unrecognized compensation expense, adjusted for estimated forfeitures, related to unvested stock options will be recognized over a weighted‑average period of approximately 2.18 years.