OTONOMY, INC. - Quarter Report: 2019 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2019

OR

For the transition period from                      to                     

Commission file number: 001-36591

Otonomy, Inc.

(Exact name of registrant as specified in its charter)

4796 Executive Drive

San Diego, California 92121

(619) 323-2200

(Address, including zip code, and telephone number, including area code, of registrant’s principal executive offices)

Securities registered pursuant to Section 12(b) of the Act:

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 every Interactive Data File required to be submitted 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 such files).    Yes  ☒    No  ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a 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.

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 Exchange Act).    Yes  ☐    No  ☒

The number of shares of the registrant’s common stock, par value $0.001, outstanding as of November 1, 2019 was 30,750,042.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

Otonomy, Inc.

Condensed Balance Sheets

(in thousands, except share and per share data)

See accompanying notes.

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Otonomy, Inc.

Condensed Statements of Operations

(in thousands, except share and per share data)

See accompanying notes.

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Otonomy, Inc.

Condensed Statements of Comprehensive Loss

(in thousands)

See accompanying notes.

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Otonomy, Inc.

Condensed Statements of Stockholders’ Equity

(in thousands, except share data)

See accompanying notes.

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Otonomy, Inc.

Condensed Statements of Stockholders’ Equity

(in thousands, except share data)

See accompanying notes.

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Otonomy, Inc.

Condensed Statements of Cash Flows

(in thousands)

See accompanying notes.

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Otonomy, Inc.

Notes to Condensed Financial Statements

(unaudited)

1. Description of Business and Basis of Presentation

Description of Business

Otonomy, Inc. (Otonomy or the Company) was incorporated in the state of Delaware on May 6, 2008. Otonomy is a biopharmaceutical company dedicated to the development of innovative therapeutics for neurotology. The Company pioneered the application of drug delivery technology to the ear in order to develop products that achieve sustained drug exposure from a single local administration. This approach is covered by a broad patent estate and is being utilized to develop a pipeline of products addressing important unmet medical needs including Ménière’s disease, hearing loss and tinnitus.

OTIVIDEX is a sustained-exposure formulation of the steroid dexamethasone that has completed two Phase 3 trials for the treatment of Ménière’s disease, with a third Phase 3 trial currently enrolling patients. OTO-313 is a sustained-exposure formulation of the potent and selective N-Methyl-D-Aspartate (NMDA) receptor antagonist gacyclidine that is currently enrolling tinnitus patients in a Phase 1/2 clinical trial. OTO-413 is a sustained-exposure formulation of brain-derived neurotrophic factor (BDNF) for the repair of cochlear synaptopathy, an underlying cause of hearing loss, that is currently enrolling hearing loss patients in a Phase 1/2 clinical trial. Otonomy also has preclinical stage programs addressing prevention of cisplatin-induced hearing loss (OTO-510) and hair cell regeneration for severe hearing loss (OTO-6XX). In October 2019, the Company entered into a collaboration with Applied Genetic Technologies Corporation (AGTC), to co-develop and co-commercialize a gene therapy to restore hearing in patients with congenital hearing loss.

In addition, the Company developed, received U.S. Food and Drug Administration (FDA) approval and commercially launched OTIPRIO (ciprofloxacin otic suspension) for use during tympanostomy tube placement (TTP) surgery in pediatric patients. OTIPRIO was also approved by the FDA for the treatment of acute otitis externa (AOE).

Basis of Presentation

The condensed financial statements have been prepared assuming the Company will continue as a going concern, which contemplates the realization of assets and the satisfaction of liabilities in the normal course of business. The Company has incurred operating losses and negative cash flows from operating activities since inception. As of September 30, 2019, the Company had cash, cash equivalents and short-term investments of $68.2 million and an accumulated deficit of $449.0 million. The Company anticipates that it will continue to incur net losses into the foreseeable future as it: (i) develops and seeks regulatory approvals for OTIVIDEX and its other product candidates; and (ii) works to develop additional product candidates through research and development programs. When additional financing is required, the Company anticipates that it will seek additional funding through future debt and/or equity financings or other sources, such as potential collaboration agreements. If the Company is not able to secure adequate additional funding, if or when necessary, the Company may be forced to make reductions in spending, extend payment terms with suppliers, liquidate assets where possible, and/or suspend or curtail planned programs. Any of these actions could materially harm the Company’s business, results of operations, and future prospects.

Unaudited Interim Financial Information

The accompanying interim condensed financial statements are unaudited. These unaudited interim condensed financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (GAAP) and following the requirements of the United States Securities and Exchange Commission (SEC) for interim reporting. As permitted under those rules, certain footnotes or other financial information that are normally required by GAAP can be condensed or omitted. In the Company’s opinion, the unaudited interim condensed financial statements have been prepared on the same basis as the audited financial statements and include all adjustments, which include only normal recurring adjustments necessary for the fair presentation of the Company’s financial position, results of operations and cash flows for the periods presented. These condensed financial statements do not include all disclosures required by GAAP and should be read in conjunction with the Company’s audited financial statements and accompanying notes for the year ended December 31, 2018 included in the Company’s Annual Report on Form 10-K, as filed with the SEC on March 4, 2019. The results presented in these unaudited condensed financial statements are not necessarily indicative of the results expected for the full fiscal year or any other interim period or any future year or period.

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2. Summary of Significant Accounting Policies

Use of Estimates

The condensed financial statements have been prepared in accordance with GAAP. The preparation of financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of product sales and expense during the reporting period. Although these estimates are based on the Company’s knowledge of current events and anticipated actions it may undertake in the future, actual results may ultimately materially differ from these estimates and assumptions.

Segment Reporting

Operating segments are identified as components of an enterprise about which separate discrete financial information is available for evaluation by the chief operating decision-maker in making decisions regarding resource allocation and assessing performance. The Company views its operations and manages its business in one operating segment.

Concentrations of Credit Risk

Financial instruments that potentially subject the Company to significant concentrations of credit risk consist primarily of cash, cash equivalents and short-term investments. The Company maintains deposits in federally insured financial institutions in excess of federally insured limits. The Company has not experienced any losses in such accounts and believes it is not exposed to significant risk on its cash balances due to the financial position of the depository institution in which those deposits are held. Additionally, the Company established guidelines regarding approved investments and maturities of investments, which are designed to maintain safety and liquidity.

Cash, Cash Equivalents and Restricted Cash

Cash and cash equivalents consist of cash and highly liquid investments with original maturities of three months or less at the date of purchase. The carrying amounts approximate fair value due to the short maturities of these instruments. Cash and cash equivalents include cash in readily available checking, savings and money market accounts.

The Company’s restricted cash consists of cash maintained in separate deposit accounts to secure a letter of credit issued by a bank to the landlord under a lease agreement for the Company’s corporate headquarters.

Short-term Investments

The Company carries short-term investments classified as available-for-sale debt securities at fair value as determined by prices for identical or similar securities at the balance sheet date. Short-term investments consist of both Level 1 and Level 2 financial instruments in the fair value hierarchy (see Note 6 – Fair Value).

Realized gains or losses of available-for-sale securities are determined using the specific identification method and net realized gains and losses are included in interest income. The Company periodically reviews available-for-sale securities for other-than temporary declines in fair value below the cost basis, and whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. The Company records unrealized gains and losses on available-for-sale debt securities as a component of other comprehensive loss within the condensed statements of comprehensive loss and as a separate component of stockholders’ equity on the condensed balance sheets. The Company does not hold equity securities in its investment portfolio.

Fair Value of Financial Instruments

The Company’s financial instruments include cash, cash equivalents, short-term investments, prepaid expenses and other assets, accounts payable, accrued expenses, accrued compensation and long-term debt. The carrying value of the Company’s cash and cash equivalents, short-term investments, prepaid expenses and other current assets, other long-term assets, accounts payable, accrued expenses, and accrued compensation approximate fair value due to the short-term nature of these items. Based on Level 3 inputs and the borrowing rates currently available for loans with similar terms, the Company believes the fair value of long-term debt approximates its carrying value.

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Accounts Receivable, net

Accounts receivable are recorded net of customer allowances for chargebacks, distributor fees and any allowance for doubtful accounts. The Company estimates the allowance for doubtful accounts based on existing contractual payment terms, actual payment patterns of its customers and individual customer circumstances. To date, the Company has determined that an allowance for doubtful accounts is not required.

Property and Equipment

Property and equipment generally consist of manufacturing equipment, office furniture and equipment, computers, and scientific equipment and are recorded at cost and depreciated using the straight-line method over the estimated useful lives of the assets (generally two to ten years). Leasehold improvements are stated at cost and are depreciated on a straight-line basis over the lesser of the remaining term of the related lease or the estimated useful lives of the assets. Repairs and maintenance costs are charged to expense as incurred.

Impairment of Long-Lived Assets

The Company assesses the value of its long-lived assets, which consist of property and equipment, for impairment on an annual basis and whenever events or changes in circumstances and the undiscounted cash flows generated by those assets indicate that the carrying amount of such assets may not be recoverable. While the Company’s current and historical operating losses and negative cash flows are indicators of impairment, the Company believes that future cash flows to be received support the carrying value of its long-lived assets. The Company had no impairments or disposals of long-lived assets during the nine months ended September 30, 2019.

Right-of-Use Assets and Lease Liabilities

The Company has operating leases for its facility and certain equipment and finance leases for certain computer equipment. Effective January 1, 2019, the Company determines if an arrangement is or contains a lease at the commencement date. Operating leases are included in Right-of-use (ROU) assets, Leases, current, and Leases, net of current on the condensed balance sheets. Finance leases are included in Property and equipment, Leases, current, and Leases, net of current on the condensed balance sheets. The Company elected not to recognize short-term leases (one year or less) on the balance sheet.

ROU assets and operating lease liabilities are recognized based on the present value of future minimum lease payments over the lease term at the commencement date. When the implicit rate of the lease is not provided or cannot be determined, the Company uses a collateralized incremental borrowing rate based on the information available at the commencement date, including lease term, in determining the present value of future payments. The Company considers payments for common area maintenance, real estate taxes and management fees to be variable non-lease components, which are expensed as incurred. Lease terms may include options to extend or terminate the lease when it is reasonably certain the Company will exercise that option. Lease expense for minimum lease payments is recognized on a straight-line basis over the lease term.

Clinical Trial Expense Accruals

As part of the process of preparing the Company’s financial statements, the Company is required to estimate expenses resulting from the Company’s obligations under contracts with vendors, contract research organizations (CROs) and consultants and under clinical site agreements in connection with conducting clinical trials. The financial terms of these contracts are subject to negotiations, which vary from contract to contract and may result in payment flows that do not match the periods over which materials or services are provided under such contracts.

The Company’s objective is to reflect the appropriate clinical trial expenses in its financial statements by recording those expenses in the period in which services are performed and efforts are expended. The Company accounts for these expenses according to the progress of the trial as measured by patient progression and the timing of various aspects of the trial. The Company determines accrual estimates through financial models taking into account discussion with applicable personnel and outside service providers as to the progress or state of its trials. During the course of a clinical trial, the Company adjusts its clinical expense if actual results differ from its estimates.

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Revenue Recognition

To recognize revenue the Company performs the following five steps: (i) identify the contract(s) with a customer, (ii) identify the performance obligations in the contract, (iii) determine the transaction price, (iv) allocate the transaction price to the performance obligations in the contract, and (v) recognize revenue when (or as) we satisfy a performance obligation. The Company only applies the five-step model to arrangements that meet the definition of a contract with a customer under Accounting Standards Codification (ASC) 606 and when it is probable the Company will collect the consideration exchanged for the goods or services transferred to the customer. At contract inception, the Company assesses the goods or services promised within each contract and determines those that are performance obligations, and then it assesses whether each promised good or service is distinct. The Company recognizes as revenue the amount of the transaction price that is allocated to the respective performance obligation when the performance obligation is satisfied.

OTIPRIO is sold to a limited number of specialty wholesale distributors. The Company recognizes revenue when its customers obtain control of OTIPRIO, typically upon delivery by the Company to these distributors. The Company has determined the delivery of OTIPRIO to its customers constitutes a single performance obligation and no other performance obligations are present. The Company’s customer contracts have standard payment terms. The Company does not offer prompt pay discounts or financing on sales and has not identified any credit risk issues.

Hospitals, ambulatory surgery centers and physician offices order OTIPRIO from the Company’s distributors and are the end users of OTIPRIO. The Company permits product returns from the distributors only if the product is damaged or is shipped or ordered in error. Product returns based on expiry are not permitted. To date, product returns have been immaterial.

Sales commissions and other incremental costs of obtaining customer contracts are expensed as incurred as the amortization periods would be less than one year or the amount is immaterial.

Transaction Price and Reserves for Variable Consideration

Revenue from product sales are recorded at the net sales price (transaction price), which includes estimates of variable consideration for which reserves are established. Components of variable consideration include trade discounts and allowances, government chargebacks, discounts and rebates and other fee for service amounts that are detailed within customer contracts relating to the sale of OTIPRIO. These reserves, as detailed below, are based on the amounts earned or accrued on our sales. Variable consideration is estimated using the most likely method, which is the single most likely outcome under the Company’s contracts and takes into consideration contractual fees, historical chargeback activity and historical Medicaid rebates. Overall, these reserves reflect the Company’s best estimates of the amount of consideration to which the Company is entitled based on the terms of the respective underlying contracts.

The amount of variable consideration included in the transaction price may be constrained and is included in the net sales price only to the extent that it is probable a significant reversal in the amount of the cumulative revenue recognized under the contract will not occur in a future period. The Company’s analyses also contemplate application of the constraint in accordance with the guidance, under which the Company determined a material reversal of revenue would not occur in a future period. Reserves are established for these discounts and allowances upon delivery of OTIPRIO by the distributor and are classified as: (i) an allowance against accounts receivable if the amount is payable to the distributor or (ii) an accrued liability if the amount is payable to a party other than the distributor. Allowances against accounts receivable relate to chargebacks and distributor fees and accruals relate primarily to government rebates. Actual amounts of consideration ultimately received may differ from the Company’s estimates. If actual results in the future vary from original estimates, the Company will adjust these estimates, which would affect net product revenue and earnings in the period such variances become known.

Trade Discounts and Allowances. The Company’s customers are specialty wholesale distributors with whom the Company has contracted to pay a fee based on a percentage of wholesale acquisition cost for sales order management, data, and distribution services. The Company determined such services received to date are not distinct from the sale of products to customers and, therefore, these payments have been recorded as a reduction of revenue within the statement of operations. This fee for service is recorded as an allowance against accounts receivable at the time of sale based on the contracted percentage.

Chargebacks. The Company estimates allowances against accounts receivable for chargebacks related to agreements with group purchasing organizations and federal contracts. Under these agreements, the Company credits distributors a chargeback amount which represents the difference between the wholesale acquisition cost and the discounted price at which eligible purchasers purchased from the distributors. At the time of sale, estimated chargebacks are recorded based on historical chargeback activity, the projected payer mix, patient population industry data and the identification of entities purchasing OTIPRIO that are eligible for discounted pricing.

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Government Rebates. The Company estimates a rebate liability in connection with a Medicaid Drug Rebate Agreement with the Centers for Medicare & Medicaid Services, which provides a rebate to participating states based on covered purchases of OTIPRIO. At the time of sale, estimated Medicaid rebates are recorded based on historical government rebate activity, the projected payer mix and Medicaid patient population industry data.

Concentration of Major Customers

The Company sells OTIPRIO to specialty wholesale distributor customers. The following table summarizes the Company’s sales to its largest customers for each of the periods presented:

Collaborative Arrangements  

The Company has entered into co-promotion agreements that fall under the scope of ASC Topic 808, Collaborative Arrangements (ASC 808). The terms of these agreements include (i) annual non-refundable non-creditable payments to the Company and reimbursement to the Company for a proportion of product support expenses as agreed upon by both parties and (ii) payments by the Company for profit sharing arising from our partners’ promotional activities. Payments to the Company are recognized as a reduction of our selling, general and administrative expenses in the statements of operations. Profit-sharing payments by the Company to our partners are recognized as selling, general and administrative expenses.

Research and Development

Research and development expenses include the costs associated with the Company’s research and development activities, including salaries, benefits, stock-based compensation expense and occupancy costs. Also included in research and development expenses are third-party costs incurred in conjunction with contract manufacturing for the Company’s research and development programs and clinical trials, including the cost of clinical trial drug supply, costs incurred by CROs and regulatory expenses. Research and development costs are expensed as incurred.

Selling, General and Administrative

Selling, general and administrative expenses include the costs associated with the Company’s executive, administrative, finance and human resource functions including salaries, benefits, stock-based compensation expense and occupancy costs. Other selling, general and administrative expenses include costs associated with prosecuting and maintaining the Company’s patent portfolio, corporate legal expenses, costs required for public company activities and infrastructure necessary for the general conduct of the Company’s business. The Company’s selling, general and administrative expenses also include OTIPRIO product support expenses, and profit-sharing fees payable to the Company’s partners, which are reduced by payments received from our partners under the Company’s co-promotion agreements.

Stock-Based Compensation

The Company accounts for stock-based compensation expense related to stock options and employee stock purchase plan (ESPP) rights by estimating the fair value on the date of grant using the Black-Scholes-Merton option pricing model. Forfeitures are recognized as incurred. For awards subject to time-based vesting conditions, stock-based compensation expense is recognized using the straight-line method.  For performance-based awards to employees, (i) the fair value of the award is determined on the grant date, (ii) we assess the probability of the individual performance milestones under the award being achieved and (iii) the fair value of the shares subject to the milestone is expensed over the implicit service period commencing once management believes the performance criteria is probable of being met.

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Income Taxes

The accounting guidance for uncertainty in income taxes prescribes a recognition threshold and measurement attribute criteria for the financial statement recognition and measurement of tax positions taken or expected to be taken in a tax return. For those benefits to be recognized, a tax position must be more likely than not to be sustained upon examination by taxing authorities based on the technical merits of the position.

The Company uses the liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and the tax reporting basis of assets and liabilities and are measured using the enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. The Company provides a valuation allowance against net deferred tax assets unless, based upon the available evidence, it is more likely than not that the deferred tax assets will be realized. When the Company establishes or reduces the valuation allowance against its deferred tax assets, its provision for income taxes will increase or decrease, respectively, in the period such determination is made.

Comprehensive Loss

Comprehensive loss is defined as the change in equity during a period from transactions and other events and/or circumstances from non-owner sources.

Net Loss Per Share

Basic net loss per common share is calculated by dividing the net loss attributable to common stockholders by the weighted-average number of common shares outstanding during the period, without consideration for potentially dilutive securities. Diluted net loss per share is computed by dividing the net loss attributable to common stockholders by the weighted-average number of common shares and potentially dilutive securities outstanding for the period determined using the treasury-stock and if-converted methods. For purposes of the diluted net loss per share calculation, potentially dilutive securities are excluded from the calculation of diluted net loss per share because their effect would be anti-dilutive and therefore, basic and diluted net loss per share were the same for all periods presented.

As of September 30, 2019 and 2018, potentially dilutive securities excluded from the calculation of diluted net loss per share consist of outstanding options to purchase 7,641,035 and 4,951,714 shares of the Company’s common stock, respectively.

Recent Accounting Pronouncements

Not Yet Adopted

In June 2016, Accounting Standards Update (ASU) No. 2016-13, Financial Instruments – Credit Losses (Topic 326): Measurement of Credit Losses on Financial Instruments (ASU 2016-13) was issued. ASU 2016-13 introduces the current expected credit loss (CECL) model, which will require an entity to measure credit losses for certain financial instruments and financial assets. ASU 2016-13 will also apply to receivables arising from revenue transactions such as accounts receivable. At each reporting period, the Company will be required to recognize an allowance that reflects the entity’s current estimate of credit losses expected to be incurred on outstanding trade receivables. ASU 2016-13 is effective for the Company beginning January 1, 2020. The Company does not expect the adoption of ASU 2016-13 to have a material effect on its financial position, results of operations or cash flows.

Recently Adopted

Effective January 1, 2019, as required, the Company adopted ASU No. 2018-02, Income Statement – Reporting Comprehensive Income (Topic 220): Reclassification of Certain Tax Effects from Accumulated Other Comprehensive Income (ASU 2018-02). ASU 2018-02 provides the option to reclassify stranded tax effects within accumulated other comprehensive income to retained earnings in each period in which the effect of the change in the U.S. federal corporate income tax rate in the Tax Reform (or portion thereof) is recorded. The adoption of ASU No. 2018-02 did not have a material impact on the Company’s financial position, results of operations or cash flows due to the presence of a full valuation allowance.

Effective January 1, 2019, as required, the Company adopted ASU No. 2018-07, Compensation – Stock Compensation (Topic 718) – Improvements to Nonemployee Share-Based Payment Accounting (ASU 2018-07). The amendments in ASU 2018-07 expand the scope of the standard to include share-based payment transactions for acquiring goods and services from nonemployees. The adoption of ASU 2018-07 did not have a material impact on its financial statements or disclosures.

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Effective January 1, 2019, as required by ASU No. 2016-02, Lease (ASU 2016-02), the Company adopted ASC 842, Leases (ASC 842), using a modified retrospective method as of the adoption date. Consequently, financial information will not be updated, and the disclosures required under ASU 2016-02 will not be provided for dates and periods prior to January 1, 2019. ASC 842 supersedes nearly all previously existing lease guidance under GAAP and requires lessees to recognize leases on the balance sheet and disclose key information about leasing arrangements.

ASC 842 establishes an ROU model that requires a lessee to recognize a ROU asset and lease liability on the balance sheet for all leases with a term longer than 12 months. ASU 2016-02 provides a number of optional practical expedients and accounting policy elections. The Company elected the package of practical expedients requiring no reassessment of whether any expired or existing contracts are or contain leases, the lease classification of any expired or existing leases, or initial direct costs for any existing leases.

The adoption of ASC 842 had a material effect on the Company’s condensed balance sheets; however, it did not have a material effect on its condensed statements of operations, comprehensive loss and cash flows. Upon adoption of ASC 842 as of January 1, 2019, the Company recognized (i) right-of-use assets of $16.7 million, net of $3.0 million of deferred rent, and (ii) lease liabilities of $19.7 million. (see Note 7 – Leases).

3. Available-for-Sale Securities

The Company invests in available-for-sale debt securities consisting of money market funds, certificates of deposit, U.S. Treasury securities and U.S. government sponsored enterprise securities. Available-for-sale debt securities are classified as part of either cash and cash equivalents or short-term investments in the condensed balance sheets. Available-for-sale debt securities with maturities of three months or less from the date of purchase have been classified as cash equivalents, and were $14.4 million and $17.2 million as of September 30, 2019 and December 31, 2018 respectively. Available-for-sale debt securities with maturities of more than three months from the date of purchase have been classified as short-term investments, and were as follows (in thousands):

As of September 30, 2019, the Company had no securities in a gross unrealized loss position. At each reporting date, the Company performs an evaluation of impairment to determine if any unrealized losses are other-than-temporary. Factors considered in determining whether a loss is other-than-temporary include the length of time and extent to which fair value has been less than the cost basis, the financial condition of the issuer, and the Company’s intent and ability to hold the investment until recovery of its amortized cost basis. Otonomy intends and has the ability, to hold any investments in unrealized loss positions until their amortized cost basis has been recovered. The Company determined there were no other-than-temporary declines in the value of any available-for-sale securities as of September 30, 2019. All the Company’s available-for-sale debt securities mature within one year.

The Company obtains the fair value of its available-for-sale debt securities from a professional pricing service. The fair values of available-for-sale debt securities are validated by comparing the fair values reported by the professional pricing service to quoted market prices or to fair values obtained from the custodian bank.

4. Balance Sheet Details

Prepaid and Other Current Assets

Prepaid and other current assets are comprised of the following (in thousands):

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Property and Equipment, Net

Property and equipment, net is comprised of the following (in thousands):

Accrued Expenses

Accrued expenses are comprised of the following (in thousands):

5. Commitments and Contingencies

Intellectual Property Licenses

The Company has acquired exclusive rights to develop patented rights, information rights and related know-how for OTIPRIO, OTIVIDEX and OTO-311 and potential future product candidates under licensing agreements with third parties. The licensing rights obligate the Company to make payments to the licensors for license fees, milestones and royalties. The Company is also responsible for patent prosecution costs, in the event such costs are incurred.

Under one of these agreements, the Company has achieved six development milestones and one regulatory milestone, totaling $2.8 million, related to its clinical trials for OTIPRIO, OTIVIDEX and OTO-311. The Company may be obligated to make additional milestone payments under the Company’s intellectual property license agreements as follows (in thousands):

In addition, the Company is obligated to pay royalties of less than five percent on net sales of OTIPRIO and on sales of any other commercial products developed using these licensed technologies. Such royalty expense for OTIPRIO is recorded to cost of product sales. The Company may also be obligated to pay to the licensors a percentage of fees received if and when the Company sublicenses the technology. As of September 30, 2019, the Company has not entered into any sublicense agreements for the licensed technologies.

Other Royalty Arrangements

The Company entered into an agreement related to OTIPRIO under which the Company is obligated to pay a one-time milestone payment of $0.5 million upon the first commercial sale of OTIPRIO and to pay royalties of less than one percent on net product sales of OTIPRIO. This milestone payment was paid during March 2016 and both this milestone payment and the royalties are recorded as selling, general and administrative expense. The royalties are payable until the later of: (i) the expiration of the last to expire patent owned by the Company in such country covering OTIPRIO; or (ii) 10 years after the first commercial sale of OTIPRIO after receipt of regulatory approval for OTIPRIO in such country.

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During October 2014, the Company entered into an exclusive license agreement with Ipsen that enables the Company to use clinical and non-clinical gacyclidine data generated by Ipsen to support worldwide development and regulatory filings for OTO-313. Under this license agreement, the Company is obligated to pay Ipsen low single-digit royalties on annual net sales of OTO-313 by the Company or its affiliates or sublicensees, up to a maximum cumulative royalty totaling $10.0 million.

6. Fair Value

The accounting guidance defines fair value, establishes a consistency framework for measuring fair value and expands disclosure for each major asset and liability category measured at fair value on either a recurring basis or nonrecurring basis. Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants on the measurement date. Accounting guidance establishes a three-tier fair value hierarchy that requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. These tiers are based on the source of the inputs and are as follows:

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

Level 2: Inputs other than quoted prices in active markets that are observable either directly or indirectly.

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

As of September 30, 2019 and December 31, 2018 the Company held no assets or liabilities measured at fair value on a nonrecurring basis and no liabilities measured at fair value on a recurring basis. The following fair value hierarchy table presents the Company’s assets measured at fair value on a recurring basis (in thousands):

7. Leases

Operating Leases

Effective January 1, 2019, the Company adopted ASC 842 using the modified retrospective approach for leases existing as of the period of adoption. The Company utilized the available practical expedients, allowing it to, among other things, carry forward its historical assessment of whether existing agreements are or contain a lease and the classification of existing lease agreements.

The Company has existing operating leases for certain office equipment and its facility with initial terms ranging from 48 months to 130 months. The facility lease has an option for the Company to extend the lease term for an additional five years; however, it is not reasonably certain the Company will exercise the option to renew when the lease term ends in 2027, and thus, the incremental term was excluded from the calculation of the lease liability. The Company has the right to terminate the lease at the end of the 94th month of the lease term if it is acquired by a third party and pays an early termination fee.

On March 31, 2019, the Company entered into a lease for certain equipment with an initial term of 24 months, which includes a purchase option at the end of the lease term based upon the then fair market value of the equipment. The lease payment includes customary principal and interest as well as costs related to the installation and setup of the equipment. The Company evaluated the lease in accordance with ASC 842 and recorded this lease as an operating lease in the condensed balance sheets.

The ROU assets associated with all the Company’s operating leases are recognized in the condensed balance sheets. Rent expense was $2.3 million and $2.4 million for the nine months ended September 30, 2019 and 2018, respectively.

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Finance Leases

On March 31, 2019, the Company entered into a lease for certain computer equipment with an initial term of 24 months, which includes an option to purchase the equipment at the end of the lease term that is expected to be exercised. The lease payment includes customary principal and interest as well as costs related to the installation and setup of the equipment. The Company classified this lease as a finance lease in the accompanying condensed balance sheets. The associated right-of-use asset is recognized within property and equipment, net in the condensed balance sheets and is being amortized over three years in accordance with the Company’s standard depreciation and amortization policies.

8. Long-term Debt

On December 31, 2018 (the Closing Date), the Company entered into a Loan and Security Agreement (the Loan Agreement), among the Company, Oxford Finance LLC, as collateral agent, and the lenders party thereto from time to time.

The Loan Agreement provides for a $15.0 million secured term loan credit facility (the Term Loan). The proceeds of the Term Loan may be used for working capital and general corporate purposes. The Company has the right to prepay the Term Loan in whole or in part at any time, subject to a prepayment fee of 3.00% if prepaid on or prior to the first anniversary of the Closing Date, 2.00% if prepaid after the first anniversary of the Closing Date and on or prior to the second anniversary of the Closing Date, and 1.00% thereafter. Amounts prepaid or repaid under the Term Loan may not be reborrowed. The Term Loan was fully funded on the Closing Date and matures on December 1, 2023 (the Maturity Date). The Company paid a facility fee of 0.75% and customary closing fees on the Closing Date.

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The Term Loan bears interest at a floating rate equal to the greater of 5.25% and the prime rate as reported in the Wall Street Journal from time to time, plus 3.75% (9.0% as of September 30, 2019, the minimum interest rate). Interest on the Term Loan is payable monthly in arrears. The Company is permitted to make interest-only payments on the Term Loan for the twenty-four (24) months following the Closing Date followed by consecutive equal monthly payments of principal and interest in arrears through the Maturity Date. The interest-only period can be extended by an additional twelve (12) months subject to the achievement of a certain clinical trial milestone. The outstanding principal amount of the Term Loan, together with accrued and unpaid interest, is due on December 1, 2023.

Upon repayment or acceleration of the Term Loan, a final payment fee equal to 4.00% of the aggregate original principal amount of the Term Loan is payable (the Final Payment). The Final Payment of $0.6 million, as well as the initial facility fee and all other direct fees and costs associated with the Loan Agreement, was recognized as a debt discount. The debt discount will be amortized to interest expense over the term of the Loan Agreement using the effective interest method.

The Company’s obligations under the Loan Agreement are secured by substantially all its assets, excluding intellectual property and subject to certain other exceptions and limitations.

The Loan Agreement contains customary affirmative covenants, including covenants regarding compliance with applicable laws and regulations, reporting requirements, payment of taxes and other obligations, and maintenance of insurance. Further, subject to certain exceptions, the Loan Agreement contains customary negative covenants limiting the ability of the Company to, among other things, sell assets, allow a change of control to occur (if the Term Loan is not repaid), make acquisitions, incur debt, grant liens, make investments, pay dividends or repurchase stock. The Company has maintained compliance with all such covenants to date. Upon the occurrence and during the continuance of an event of default, the lenders may declare all outstanding principal and accrued and unpaid interest under the Loan Agreement immediately due and payable, increase the applicable rate of interest by 5.00%, and exercise the other rights and remedies provided for under the Loan Agreement and related loan documents. The events of default under the Loan Agreement include payment defaults, breaches of covenants or representations and warranties, material adverse changes, certain bankruptcy events, cross defaults with certain other indebtedness, and judgment defaults.

Interest expense, including amortization of the debt discount, related to the Loan Agreement totaled $0.4 million and $1.2 million for the three and nine months ended September 30, 2019, respectively. Accrued interest, included in accounts payable, was $0.1 million as of September 30, 2019. The outstanding Term Loan balance was $14.9 million as of September 30, 2019, inclusive of accretion of the final payment and net unamortized debt discount.

9. Stockholders’ Equity

Common Stock Reserved for Future Issuance

Shares of common stock reserved for future issuance are as follows:

10. Stock-Based Compensation

The 2014 Equity Incentive Plan (the 2014 Plan) permits the grant of incentive stock options to the Company’s employees and the grant of nonstatutory stock options, restricted stock, restricted stock units, stock appreciation rights, performance units and performance shares to the Company’s employees, directors and consultants. Options granted under the 2014 Plan are generally scheduled to vest over four years, subject to continued service, and subject to certain acceleration of vesting provisions, expire no later than 10 years from the date of grant. Options granted under the 2014 Plan must have a per share exercise price equal to at least 100% of the fair market value of a shares of the common stock as of the date of grant.

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The following table summarizes stock option activity for the nine months ended September 30, 2019 (share amounts in thousands):

Performance-based Awards

In February 2018, the Company granted its chief executive officer a stock option for the purchase of 250,000 shares of the Company’s common stock which is subject to time-based vesting and certain performance-based conditions. Specifically, subject to continued service the option was scheduled to vest upon achievement of a clinical development milestone. On the grant date, the Company determined the fair value of the award and determined achievement of the milestone was probable of occurrence and recognized stock-based compensation expense, based upon the grant date fair value, over the implicit service period. The milestone was achieved, and the option grant vested and was fully expensed as of December 31, 2018.

Option Exchange

On December 20, 2017, the Company commenced an option exchange program (Option Exchange) which allowed eligible employees to exchange certain outstanding stock options (Eligible Options), whether vested or unvested, with an exercise price greater than $12.00 per share, for new stock options.  Non-employee members of our Board of Directors were not eligible to participate in the Option Exchange. The Option Exchange expired on January 19, 2018. The closing price of the Company’s common stock on that date was $5.675 per share.  

Pursuant to the terms and conditions of the Option Exchange, the Company accepted for exchange Eligible Options to purchase a total of 1,992,000 shares of the Company’s common stock, representing approximately 81.51% of the total shares of common stock underlying the Eligible Options. All surrendered options were canceled effective as of the expiration of the Exchange Offer and in exchange on January 19, 2018, the Company granted new options to purchase an aggregate of 1,570,328 shares of the Company’s common stock with an exercise price of $5.675 per share pursuant to the terms of the Option Exchange and the Company’s 2014 Equity Incentive Plan.  

These new options vest over one to three years, subject to the terms of the Option Exchange and expire eight years from the date of grant. The Company determined this option exchange was an option modification. The exchange of these stock options was treated as a modification for accounting purposes. The difference in the fair value of the canceled options immediately prior to the cancelation and the fair value of the modified options resulted in incremental value, of approximately $0.6 million, which was calculated using the Black-Scholes-Merton option pricing model. Total stock-based compensation expense to be recognized over the requisite service period is equal to remaining unrecognized expense for the exchanged option, as of the exchange date, plus the incremental value of the modification to the award.

Total non-cash stock-based compensation expense recognized in the accompanying condensed statements of operations is as follows (in thousands):

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11. Co-Promotion Agreements

On August 2, 2018, the Company entered into a co-promotion agreement with Mission Pharmacal Company (the Mission Co-Promotion Agreement) that provided Mission Pharmacal Company (Mission) with an exclusive right to promote OTIPRIO for AOE in pediatrician and primary care physician offices as well as urgent care clinics in the United States. In August 2019, Mission informed the Company of its non-renewal of the co-promotion agreement.

On April 8, 2019, the Company entered into a co-promotion agreement with Glenmark Therapeutics Inc., USA (the Glenmark Co-Promotion Agreement) that provided Glenmark Therapeutics Inc., USA (Glenmark) with an exclusive right to promote OTIPRIO for AOE to ear, nose and throat (ENT) physicians in the United States. In July 2019, Glenmark informed the Company of its early discontinuation of OTIPRIO promotional support activities due to the delay in FDA approval of its Ryaltris™ allergy product, and the impact of such delay on its business operations. In September 2019, the Company reached a settlement with Glenmark regarding the financial and contractual terms impacted by this decision that included committed payments by Glenmark totaling $1.0 million.

The Mission Co-Promotion Agreement and the Glenmark Co-Promotion Agreement (each, a Co-Promotion Agreement) are within the scope of ASC 808, as the parties were active participants and exposed to the risks and rewards of the collaborative activity. Mission and Glenmark (each, a Partner) made non-refundable, non-creditable payments to the Company as partial consideration of the OTIPRIO product support activities provided by the Company and as reimbursement for certain expenses incurred by the Company to obtain and maintain FDA approval for use of OTIPRIO in AOE. In addition, each Partner reimbursed the Company for a proportion of product support expenses. All such payments are recognized proportionately with the performance of the underlying services and accounted for as reductions to selling, general and administrative expense. Each Partner agreed to bear the costs incurred for its promotion of OTIPRIO. In exchange for its promotional services, each Partner was entitled to receive a share of gross profits totaling more than 50% from the sale of OTIPRIO to each Partner’s accounts. The Company’s payments to each Partner for its portion of the gross profit has been recognized as selling, general and administrative expense in the Company’s condensed statement of operations. The Company was the principal in the product sale of OTIPRIO and recognized all revenue and related cost of product sales. The Company retained and continues to retain all commercial rights for other customer segments for AOE and for use of OTIPRIO in other indications.

The Company does not consider performing product support services for its Partners to be a part of its ongoing major or central operations and, thus, the associated payments are not considered revenue, nor do they fall under ASC 606. The Company considers these activities to be collaborative activities under the scope of ASC 808, and recognizes the shared profits and losses in the periods in which they occurred. For the three and nine months ended September 30, 2019, the Company recognized reductions in selling, general and administrative expenses related to the Co-Promotion Agreements of $1.5 million and $2.6 million, respectively.

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The following discussion and analysis of our financial condition and results of operations should be read together with our financial statements and the other financial information appearing elsewhere in this Quarterly Report on Form 10-Q. These statements generally relate to future events or to our future financial performance and involve known and unknown risks, uncertainties and other factors which 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. The following discussion and analysis contains forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. Our actual results and the timing of events may differ materially from those discussed in our forward-looking statements as a result of various factors, including those discussed below and those discussed in the section titled “Risk Factors” included in this Quarterly Report on Form 10-Q.

Forward-looking statements include, but are not limited to, statements about:

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These forward-looking statements are subject to a number of risks, uncertainties, and assumptions, including but not limited to: our limited operating history and our expectation that we will incur significant losses for the foreseeable future; our ability to obtain additional financing; our dependence on the clinical, regulatory and commercial success of OTIVIDEX and advancement of additional product candidates, such as OTO-313 and OTO-413, through clinical development to regulatory approval and commercialization, the uncertainties inherent in the clinical drug development process, including, without limitation, our ability to adequately demonstrate the safety and efficacy of our product candidates, the nonclinical and clinical results for our product candidates, which may not support further development, and challenges related to patient enrollment in clinical trials; our ability to obtain regulatory approval for our product candidates; side effects or adverse events associated with our product candidates; competition in the biopharmaceutical industry; our dependence on third parties to conduct nonclinical studies and clinical trials; the timing and outcome of hospital pharmacy and therapeutics reviews and other facility reviews; the impact of coverage and reimbursement decisions by third-party payors on the pricing and market acceptance of OTIPRIO; our dependence on third parties for the manufacture of OTIPRIO and our product candidates; our dependence on a small number of suppliers for raw materials; our ability to protect our intellectual property related to OTIPRIO and our product candidates in the United States and throughout the world; expectations regarding potential market size, opportunity and growth; our ability to manage operating expenses; implementation of our business model and strategic plans for our business, products and technology; the risk of the occurrence of any event, change or other circumstance that could give rise to the termination of OTIPRIO promotional agreements; the risks of the occurrence of any event, change or other circumstances that could impact our ability to repay or comply with the terms of the loan provided by Oxford Finance LLC; and other risks. These forward-looking statements reflect our beliefs and views with respect to future events and are based on estimates and assumptions as of the date of this Quarterly Report on Form 10-Q and are subject to risks and uncertainties. We discuss many of these risks in greater detail in the section titled “Risk Factors” included in Part II, Item 1A and elsewhere in this report. Moreover, we operate in a very competitive and rapidly changing environment. New risks emerge from time to time. It is not possible for our management to predict all risks, nor can we assess the impact of all factors on our business or the extent to which any factor, or combination of factors, may cause actual results to differ materially from those contained in any forward-looking statements we may make. Given these uncertainties, you should not place undue reliance on these forward-looking statements. We qualify all the forward-looking statements in this Quarterly Report on Form 10-Q by these cautionary statements. Except as required by law, we assume no obligation to update these forward-looking statements publicly, or to update the reasons actual results could differ materially from those anticipated in any forward-looking statements, whether as a result of new information, future events or otherwise.

Otonomy, the Otonomy logo, OTIPRIO, OTIVIDEX and other trademarks or service marks of Otonomy appearing in this report are the property of Otonomy. Trade names, trademarks and service marks of other companies appearing in this report are the property of their respective holders. We have generally omitted the ®, ™ and other designations, as applicable, in this report.

Overview

We are a biopharmaceutical company dedicated to the development of innovative therapeutics for neurotology. We pioneered the application of drug delivery technology to the ear in order to develop products that achieve sustained drug exposure from a single local administration. This approach is covered by a broad patent estate and is being utilized to develop a pipeline of products addressing important unmet medical needs including Ménière’s disease, hearing loss and tinnitus.

OTIVIDEX is a steroid in development for the treatment of Ménière’s disease. Two Phase 3 trials in Ménière’s disease patients were completed in the second half of 2017. The AVERTS-2 trial, conducted in Europe, achieved its primary endpoint (p value = 0.029), while the AVERTS-1 trial, conducted in the United States, did not (p value = 0.62). Based on a Type C meeting with the FDA, we believe that one additional successful pivotal trial is sufficient to support the U.S. registration of OTIVIDEX in Ménière’s disease. We are enrolling patients in a Phase 3 trial for Ménière’s disease with results expected in the third quarter of 2020.

OTO-313 is a sustained-exposure formulation of gacyclidine, a potent and selective NMDA receptor antagonist, in development for the treatment of tinnitus. A Phase 1/2 clinical trial for OTO-313 is enrolling tinnitus patients with results expected in the second quarter of 2020.

OTO-413 is a sustained exposure formulation of BDNF in development for the repair of cochlear synaptopathy, an underlying pathology in age-related and noise-induced hearing loss that manifests as speech-in-noise hearing difficulty. A Phase 1/2 clinical trial for OTO-413 is enrolling hearing loss patients with results expected in the second half of 2020.

Otonomy also has preclinical stage programs addressing prevention of cisplatin-induced hearing loss (OTO-510) and hair cell regeneration for severe hearing loss (OTO-6XX).

In October 2019, Otonomy and AGTC entered into a strategic collaboration to co-develop and co-commercialize an adeno-associated virus (AAV)-based gene therapy to restore hearing in patients with congenital hearing loss caused by a mutation in the gap junction protein beta 2 gene (GJB2).

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In addition, we developed, received FDA approval for and commercially launched OTIPRIO (ciprofloxacin otic suspension) for use during tympanostomy tube placement (TTP) surgery in pediatric patients. OTIPRIO was also approved by the FDA for the treatment of acute otitis externa (AOE). We entered into a co-promotion partnership with Mission in August 2018 and with Glenmark in April 2019 to support the promotion of OTIPRIO for the treatment of AOE in physician offices. In July 2019, Glenmark informed us of its early discontinuation of OTIPRIO promotional support activities due to the delay in FDA approval of its Ryaltris allergy product, and the impact of such delay on its business operations. In September 2019, we reached a settlement with Glenmark regarding the financial and contractual terms impacted by this decision that included committed payments by Glenmark totaling $1.0 million. In August 2019, Mission informed us of its non-renewal of the co-promotion agreement.

We have a limited operating history. Since our inception in 2008, we have devoted substantially all our efforts to developing and commercializing OTIPRIO, developing our current product candidates, and providing general and administrative support for these operations. As of September 30, 2019, we had cash, cash equivalents and short-term investments of $68.2 million and long-term debt of $14.9 million, net of debt discounts.

We have never been profitable, and as of September 30, 2019, we had an accumulated deficit of $449.0 million. Our net losses were $10.0 million and $12.5 million for the three months ended September 30, 2019 and 2018, respectively, and $33.8 million and $37.5 million for the nine months ended September 30, 2019 and 2018, respectively. Substantially all our net losses have resulted from research and development expenses related to our clinical trials and product development activities, commercialization expenses to launch OTIPRIO in the U.S. market, and other general and administrative expenses.

We expect to continue to incur significant expenses and operating losses for the foreseeable future as we continue to develop, seek regulatory approval, and, if approved, commercialize our product candidates. In the near term, we anticipate our expenses will continue to be substantial as we:

We will require additional financing to complete the development of and, if approved, commercialize, OTIVIDEX, OTO-313, OTO-413 and any other product candidates. We believe we will continue to expend substantial resources for the foreseeable future for the development of OTIVIDEX, OTO-313, OTO-413 and any other product candidates we may choose to pursue. These expenditures will include costs associated with marketing and selling any products approved for sale, manufacturing, preparing regulatory submissions, and conducting nonclinical studies and clinical trials. The amount and timing of our future funding requirements will depend on many factors, including the pace and results of our clinical development efforts, the timing and nature of the regulatory approval process for our product candidates, and the revenue generated by OTIPRIO and our other product candidates, if approved. When additional financing is required, we anticipate we will seek funding through public or private equity or debt financings or other sources, such as potential collaboration arrangements. We may not be able to raise capital on terms acceptable to us, or at all. Our failure to raise capital as and when needed could have a negative impact on our financial condition and our ability to pursue our business strategies. We believe our existing cash and cash equivalents and short-term investments will be sufficient to fund our currently planned operations for a period of at least twelve months from the date of this report.

In November 2008, we entered into an exclusive license agreement with the Regents of the University of California (UC). Under the license agreement, UC granted us an exclusive license under their rights to patents and applications that are co-developed and co-owned with us for the treatment of human otic diseases. Our financial obligations under the license agreement include development and regulatory milestone payments of up to $2.7 million per licensed product, of which $1.9 million has been paid for OTIPRIO, $0.8 million has been paid for OTIVIDEX, and $0.1 million has been paid for OTO-311 (but such milestone payments are reduced by 75% for any orphan indication product), and a low single-digit royalty on net sales by us or our affiliates of licensed products. In addition, for each sublicense we grant we are obligated to pay UC a fixed percentage of all royalties as well as a sliding-scale percentage of non-royalty sublicense fees received by us under such sublicense, with such percentage depending on the licensed product’s stage of development when sublicensed to such third party. We have the right to offset a certain amount of third-party royalties, milestone fees or sublicense fees against the foregoing financial obligations, provided such third-party royalties or fees are paid by us in consideration for intellectual property rights necessary to commercialize a licensed product.

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In April 2013, we entered into an exclusive license agreement with DURECT Corporation (Durect), as part of an asset transfer agreement between us and IncuMed LLC, an affiliate of the NeuroSystec Corporation. Under this license agreement, Durect granted us an exclusive, worldwide, royalty-bearing license under Durect’s rights to certain patents and applications covering our OTO-313 product candidate, as well as certain related know-how. Under this license agreement and the asset transfer agreement, we are obligated to make one-time milestone payments of up to $7.5 million for the first licensed product. Upon commercializing a licensed product, we are obligated to pay Durect tiered, low single-digit royalties on annual net sales by us or our affiliates or sublicensees of the licensed products, and we have the right to offset a certain amount of third-party license fees or royalties against such royalty payments to Durect. In addition, each sublicense we grant to a third party is subject to payment to Durect of a low double-digit percentage of all non-royalty payments we receive under such sublicense. Additionally, we are also obligated to pay the Institut National de la Santé et de la Recherche Médicale (INSERM), on behalf of Durect, for a low single-digit royalty payment on net sales by us or our affiliates or sublicensees upon commercialization of the licensed product. The foregoing royalty payment obligation to Durect would continue on a product-by-product and country-by-country basis until expiration or determination of invalidity of the last valid claim within the licensed patents that cover the licensed product, and the payment obligation to INSERM would continue so long as Durect’s license from INSERM remains in effect.

Financial Operations Overview

Revenue

In December 2015, OTIPRIO was approved by the FDA for the treatment of pediatric patients with bilateral otitis media with effusion undergoing TTP surgery. In March 2016, we began sales of OTIPRIO in the United States to our network of specialty distributors who fill orders received from hospitals and ambulatory surgery centers who are the primary end user customers of OTIPRIO for use during TTP surgery. We also entered into co-promotion partnerships to support the promotion of OTIPRIO for the treatment of AOE in physician offices. In July 2019, we were notified by Glenmark of its early discontinuation of OTIPRIO promotional support activities due to the delay in FDA approval of its Ryaltris allergy product, and the impact of such delay on its business operations. In August 2019, Mission informed us of its non-renewal of the co-promotion agreement.

We recognize revenue on sales of OTIPRIO upon delivery to our distributors. Product sales are recorded net of estimated chargebacks, government rebates and distributor fees.

Prior to March 2016 we had not generated revenue. We do not expect to generate any revenue from any of our product candidates unless and until we obtain regulatory approval and commercialize our products or enter into collaborative agreements with third parties.

Operating Expenses

Cost of product sales

Cost of product sales consists primarily of direct and indirect costs related to the manufacturing of OTIPRIO, including third-party manufacturing costs, allocation of overhead costs and royalty payments based on OTIPRIO sales.

Research and development expenses

Our research and development expenses primarily consist of costs associated with the nonclinical and clinical development of our product candidates and the development of OTIPRIO for additional indications.

Our research and development expenses include:

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We expense our internal and third-party research and development expenses as incurred.

The following table summarizes our research and development expenses (in thousands) for OTIPRIO and our current product candidates:

We expect our research and development expenses to continue to be substantial for the foreseeable future as we advance our product candidates through their respective development programs. The process of conducting nonclinical studies and clinical trials necessary to obtain regulatory approval is costly and time consuming. We may never succeed in achieving regulatory approval for our product candidates. The probability of success will be affected by numerous factors, including nonclinical data, clinical data, competition, manufacturing capability and commercial viability. We are responsible for all of the research and development costs for our programs.

Completion dates and completion costs can vary significantly for each of our clinical development programs and are difficult to predict. We therefore cannot estimate with any degree of certainty the costs we will incur in connection with development of our product candidates. We anticipate that we will make determinations as to which programs and product candidates to pursue and how much funding to direct to each program and product candidate on an ongoing basis in response to the results of ongoing and future clinical trials, regulatory developments, and our ongoing assessments as to each current or future product candidate’s commercial potential. We may need to raise substantial additional capital in the future to complete the development of and, if approved, commercialize, our product candidates. We may enter into collaborative agreements in the future in order to conduct clinical trials and gain regulatory approval of our product candidates, particularly in markets outside of the United States. We cannot forecast which programs or product candidates may be subject to future collaborations, when such arrangements will be secured, if at all, and to what degree such arrangements would affect our development plans and overall capital requirements.

The costs of clinical trials may vary significantly over the life of a program owing to the following:

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Selling, general and administrative expenses

Our selling, general and administrative expenses consist primarily of employee-related expenses, including salaries, benefits, travel and stock-based compensation expense, as well as other related costs for our employees and consultants in executive, administrative, finance and human resource functions. Other selling, general and administrative expenses include facility-related costs not otherwise included in research and development, costs associated with prosecuting and maintaining our patent portfolio and corporate legal expenses, costs required for public company activities and infrastructure necessary for the general conduct of our business, and OTIPRIO product support expenses and profit-sharing fees payable to our co-promotion partners, which are reduced by payments received from them.

We expect our selling, general and administrative expenses to be substantial as we support development of our product candidates, and as we incur ongoing expenses related to audit, legal, regulatory, and tax-related services associated with maintaining compliance with stock exchange listing and SEC requirements, director’s and officer’s liability insurance premiums, and investor relations-related expenses.

Other Income (Expense)

Other income (expense) primarily consists of interest income earned on cash and cash equivalents and short-term investments and interest expense related to our long-term debt and finance leases.

Critical Accounting Policies and Significant Judgments and Estimates

Our management’s discussion and analysis of our financial condition and results of operations is based on our condensed financial statements. Our financial statements are prepared in accordance with generally accepted accounting principles in the United States of America. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, and expenses and the disclosure of contingent assets and liabilities in our financial statements. On an ongoing basis, we evaluate our estimates and assumptions, including those related to net product sales, accrued expenses and stock-based compensation. We base our estimates on our historical experience, known trends and events and various other factors that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the estimates, assumptions and judgments involved in the accounting policies described in the section titled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in Item 7 of our Annual Report on Form 10-K for the year ended December 31, 2018, as filed with the SEC on March 4, 2019, have the greatest potential impact on our financial statements, so we consider them to be our critical accounting policies and estimates. In addition, effective January 1, 2019, we adopted ASC 842, as described below. ASC 842 replaces our previous method of accounting for leases.

Leases

ROU assets and operating lease liabilities are recognized based on the present value of the future minimum lease payments over the lease term at commencement date. The discount rate implicit within our leases is generally not determinable, therefore, we use a collateralized incremental borrowing rate based on the information available at commencement date, including lease term, in determining the present value of future payments. We estimated our collateralized incremental borrowing rate at January 1, 2019 to be 10.0% based on the remaining term of our operating leases and available interest rates. The below table summarizes the differences in our ROU assets and operating lease liabilities had we utilized an incremental borrowing rate of 9.0% or 11.0% on January 1, 2019 (in thousands, except percentages).  Neither change in estimate would have a material impact on our condensed statements of operations, comprehensive loss and cash flows.  

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Stock-based Compensation

We recognize non-cash expense for the fair value of all stock options and other share-based awards. We use the Black-Scholes-Merton option valuation model to calculate the fair value of stock options, using the single-option award approach and straight-line attribution method. For options granted to employees and directors, we recognize the resulting fair value as expense on a straight-line basis over the vesting period of each respective stock option, generally four years.

We have granted stock options that vest upon achievement of certain performance criteria, or Performance Awards. For performance-based awards to employees, (i) the fair value of the award is determined on the grant date, (ii) we assess the probability of the individual performance milestones under the award being achieved and (iii) the fair value of the shares subject to the milestone is expensed over the implicit service period commencing once management believes the performance criteria is probable of being met.

In January 2018, we completed an option exchange program (Option Exchange) which allowed eligible employees to exchange certain outstanding stock options (Eligible Options), whether vested or unvested, with an exercise price greater than $12.00 per share, for new stock options.  These new options vest over one to three years, subject to the terms of the Option Exchange and expire eight years from the date of grant. We determined this Option Exchange was an option modification. The exchange of these stock options was treated as a modification for accounting purposes. The difference in the fair value of the canceled options immediately prior to the cancellation and the fair value of the modified options resulted in incremental value, of approximately $0.6 million, which was calculated using the Black-Scholes-Merton option pricing model. Total stock-based compensation expense to be recognized over the requisite service period is equal to the remaining unrecognized expense for the exchanged option, as of the exchange date, plus the incremental value of the modification to the award.

Clinical Trial Expense Accruals

As part of the process of preparing our financial statements, we are required to estimate expenses resulting from our obligations under contracts with vendors, CROs and consultants and under clinical site agreements in connection with conducting clinical trials. The financial terms of these contracts vary and may result in payment flows that do not match the periods over which materials or services are provided under such contracts.

Our objective is to reflect the appropriate trial expenses in our financial statements by recording those expenses in the period in which services are performed and efforts are expended. We account for these expenses according to the progress of the trial as measured by patient progression and the timing of various aspects of the trial. We determine accrual estimates through financial models taking into account discussion with applicable personnel and outside service providers as to the progress of trials. During the course of a clinical trial, we adjust the clinical expense recognition if actual results differ from our estimates. We make estimates of accrued expenses as of each balance sheet date based on the facts and circumstances known at that time. Our clinical trial accruals are dependent upon accurate reporting by CROs and other third-party vendors. Although we do not expect our estimates to differ materially from amounts actually incurred, our understanding of the status and timing of services performed relative to the actual status and timing of services performed may vary and may result in reporting amounts that are too high or too low for any particular period. For the three and nine months ended September 30, 2019 and 2018, there were no material adjustments to our prior period estimates of accrued expenses for clinical trials.

Results of Operations

Comparison of the Three Months Ended September 30, 2019 and 2018

The following table sets forth the significant components of our results of operations for the periods presented (in thousands):