ReShape Lifesciences Inc. - Quarter Report: 2016 September (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2016

or

Commission File Number: 001-37897

OBALON THERAPEUTICS, INC.

(Exact Name of Registrant as Specified in Its Charter)

(760) 795-6558

(Registrant’s Telephone Number, Including Area Code)

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or 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 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 Securities Exchange Act of 1934.

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

Total shares of common stock outstanding as of the close of business on November 7, 2016:

TABLE OF CONTENTS

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PART I. FINANCIAL INFORMATION

OBALON THERAPEUTICS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except shares and par value data)

See accompanying notes to unaudited interim condensed consolidated financial statements.

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OBALON THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(in thousands, except shares and per share data)

See accompanying notes to unaudited interim condensed consolidated financial statements.

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OBALON THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

See accompanying notes to unaudited interim condensed consolidated financial statements.

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OBALON THERAPEUTICS, INC.

NOTES TO UNAUDITED INTERIM CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Obalon Therapeutics, Inc., or the Company, was incorporated in the state of Delaware on January 2, 2008. The Company is a commercial-stage medical device company focused on developing and commercializing innovative medical devices to treat obese and overweight people. Using its patented technology, the Company has developed the Obalon balloon system, the first and only FDA approved swallowable, gas-filled intragastric balloon designed to provide progressive and sustained weight loss in obese patients.

The consolidated financial statements include the accounts of Obalon Therapeutics, Inc., and its wholly owned subsidiaries, Obalon Italy SRL and Obalon Therapeutics, LLC. Obalon Therapeutics, LLC is a shell Company, which owns 99% of Obalon Mexico DE RL CV. All intercompany balances and transactions have been eliminated in consolidation.

The Company’s principal operations are located in Carlsbad, California and it operates in one business segment.

As of September 30, 2016, the Company has devoted a substantial portion of its efforts to product development, raising capital, and building infrastructure. The Company has incurred operating losses and has experienced negative cash flows from operations since its inception. In July 2012, the Company realized initial revenue from its planned principal operations. The Company recognized revenue, including revenue from related parties, of $2.6 and $3.1 million for the nine months ended September 30, 2016 and 2015, respectively. However, the Company has not yet established an ongoing source of revenues sufficient to cover its operating costs and has funded its activities to date almost exclusively from debt and equity financings. On September 8, 2016, the Company received premarket approval from the U.S. Food and Drug Administration, or FDA, to market the Obalon balloon system for temporary use to facilitate weight loss in obese adults with a body mass index, or BMI of 30 to 40 who have failed to lose weight through diet and exercise. The Obalon balloon system is intended to be used as an adjunct to a moderate intensity diet and behavior modification program. For all periods presented, all sales are to customers outside of the United States.

Initial Public Offering

On October 5, 2016, the Company’s Registration Statement on Form S-1/A (File No. 333-213551) relating to the initial public offering, or IPO, of its common stock was declared effective by the Securities and Exchange Commission, or SEC. Pursuant to such Registration Statement, the Company sold an aggregate of 5,000,000 shares of its common stock at a price of $15.00 per share for aggregate cash proceeds of approximately $67.4 million, net of underwriting discounts, commissions, and estimated offering costs. The sale of 5,000,000 shares in the IPO closed on October 12, 2016.

On October 12, 2016, immediately prior to the closing of the IPO, all outstanding shares of convertible preferred stock converted into 10,360,419 shares of common stock and 12,217 shares of common stock were issued upon the automatic net exercise of two warrants.

September 2016 Reverse Stock Split

In September 2016, the Company’s board of directors approved an amendment to the Company’s amended and restated certificate of incorporation to effect a reverse stock split of the Company’s issued and outstanding common stock and convertible preferred stock at a 2.9-to-1 ratio, which was effected on September 23, 2016. All share and per share information included in the accompanying condensed consolidated financial statements and notes to the condensed consolidated financial statements have been retroactively adjusted to reflect the reverse stock split for the Company’s common and preferred stock for all periods presented.

Liquidity

As reflected in the accompanying condensed consolidated financial statements, the Company has a limited operating history and the sales and income potential of the Company’s business are unproven. The Company has not been profitable since inception, and as of September 30, 2016, its accumulated deficit was $69.1 million. Since inception, the Company has financed its operations primarily through private placements of preferred securities and, to a lesser extent, debt financing arrangements. The Company expects to continue to incur net losses for the foreseeable future as it builds its sales and marketing organization, prepares for and proceeds to commercialization of its product in the United States and continues research and development efforts. The Company may need additional funding to pay expenses relating to its operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding, if needed, may not be available to the Company on acceptable terms, or at all. The failure to obtain sufficient funds on acceptable terms could have a material adverse effect on the Company’s business, results of operations or financial condition.

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There were no significant changes to the accounting policies during the nine months ended September 30, 2016, from the significant accounting policies described in Note 2 of the “Notes to Consolidated Financial Statements” in the Prospectus dated and filed with the SEC on September 26, 2016, pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended, or Prospectus.

Use of Estimates

The preparation of financial statements in conformity with Generally Accepted Accounting Principles, or GAAP, requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of assets and liabilities at the date of the financial statements and the reported amounts of expenses during the reporting period. On an ongoing basis, management evaluates its estimates, including those related to the warrant liability, stock-based compensation, and income tax uncertainties.

Reported amounts and note disclosures reflect the overall economic conditions that are most likely to occur and anticipated measures management intends to take. Actual results could differ materially from those estimates. All revisions to accounting estimates are recognized in the period in which the estimates are revised and in any future periods affected.

Unaudited Interim Condensed Consolidated Financial Statements

The interim condensed consolidated financial statements as of September 30, 2016 and for the nine months ended September 30, 2016 and 2015 are unaudited. The unaudited interim condensed consolidated financial statements have been prepared on the same basis as the annual financial statements and reflect, in the opinion of management, all adjustments of a normal and recurring nature that are necessary for the fair presentation of the Company’s condensed consolidated financial position as of September 30, 2016 and its consolidated results of operations and cash flows for the nine months ended September 30, 2016 and 2015. The financial data and other information disclosed in these notes to the condensed consolidated financial statements related to the nine-month periods are also unaudited. The results of operations for the nine months ended September 30, 2016 are not necessarily indicative of the results to be expected for the year ending December 31, 2016 or for any other future annual or interim period. The balance sheet as of December 31, 2015 included herein was derived from the audited financial statements as of that date. These financial statements should be read in conjunction with the Company’s audited financial statements included in the Prospectus dated October 5, 2016, filed with the SEC on October 6, 2016 pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended, or the Prospectus.

Short-Term Investments

The Company classifies its investments as available-for-sale and records such assets at estimated fair value in the balance sheet, with unrealized gains and losses, if any, reported as a component of other comprehensive loss within the consolidated statements of operations and comprehensive loss. All of the Company’s short-term investments are U.S. Treasury notes with maturities of less than one year. For the three and nine months ended September 30, 2016 and 2015, unrealized losses were immaterial. Realized gains and losses would be calculated on the specific-identification method and recorded as interest income (expense). There have been no material realized gains and losses for the three and nine months ended September 30, 2016 or 2015. The Company periodically reviews available-for-sale securities for other-than-temporary declines in fair value below the cost basis whenever events or changes in circumstances indicate the carrying amount of an asset may not be recoverable.

Fair Value Measurements

The carrying values of the Company’s financial instruments, including cash and cash equivalents, accounts receivable, accounts receivable from related party, accounts payable, and accrued expenses approximate their fair values due to the short maturity of these instruments. The carrying value of the term loan approximates its fair value as the interest rate and other terms are that which are currently available to the Company.

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The Company utilizes valuation techniques that maximize the use of observable inputs and minimize the use of unobservable inputs to the extent possible. The Company determines fair value based on assumptions that market participants would use in pricing an asset or liability in the principal or most advantageous market. When considering market participant assumptions in fair value measurements, the following fair value hierarchy distinguishes between observable and unobservable inputs, which are categorized in one of the following levels in accordance with authoritative accounting guidance:

Deferred Offering Costs

Deferred offering costs, which primarily consist of direct incremental legal and accounting fees relating to the IPO, are capitalized. The deferred offering costs will be offset against the IPO proceeds upon the consummation of the offering, which occurred on October 5, 2016. As of September 30, 2016, $2.4 million of deferred offering costs have been incurred, which are included in other current assets in the accompanying condensed consolidated balance sheet. No deferred offering costs were capitalized as of December 31, 2015.

Net Loss per Share

Basic net loss per share is calculated by dividing the net loss by the weighted-average number of shares of common stock outstanding during the period without consideration for common stock equivalents. Diluted net loss per share is the same as basic net loss per common share, since the effects of potentially dilutive securities are anti-dilutive.

Dilutive common stock equivalents are comprised of convertible preferred stock, warrants and unexercised stock options outstanding under the Company’s equity plan.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board, or FASB, issued Accounting Standard Update, or ASU, 2014-09, Revenue from Contracts with Customers. ASU 2014-09 outlines a comprehensive revenue recognition model and supersedes most current revenue recognition guidance. Entities are able to use one of three prescribed transition methods. In August 2015, the FASB issued ASU 2015-14 to defer the effective date of ASU 2014-09 by one year and allow early adoption for all entities but not before the original public entity effective date.  ASU 2014-09 is effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2017.

In August 2014, the FASB issued ASU 2014-15, Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern. ASU 2014-15 requires management to evaluate relevant conditions, events and certain management plans that are known or reasonably knowable that when, considered in the aggregate, raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued, for both annual and interim periods. ASU 2014-15 also requires certain disclosures around management’s plans and evaluation, as well as the plans, if any, that are intended to mitigate those conditions or events that will alleviate the substantial doubt. ASU 2014-15 is effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2016. The Company does not anticipate that the adoption of ASU 2014-15 will have a material impact on its consolidated financial statements.

In July 2015, FASB issued ASU 2015-11, Simplifying the Measurement of Inventory. This update applies to companies that measure inventory on a first in, first out, or FIFO, or average cost basis. Under this update, companies are to measure their inventory at the lower of cost and net realizable value. Net realizable value is the estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion. The amendments in this update are effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2016 with earlier application permitted as of the beginning of an interim or annual reporting period. The Company does not anticipate that the adoption of ASU 2015-11 will have a material impact on its consolidated financial statements.

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In February 2016, the FASB issued ASU 2016-02, Leases. Under this new guidance, at the commencement date, lessees will be required to recognize (i) a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis and (ii) a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. This guidance is not applicable for leases with a term of 12 months or less. The new standard is effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.

In March 2016, the FASB issued ASU No. 2016-08, Revenue from Contracts with Customers (Topic 606): Principal versus Agent Considerations (Reporting Revenue Gross versus Net), which clarifies the guidance in ASU No. 2014-09 when evaluating when another party, along with the entity, is involved in providing a good or service to a customer. In April 2016, the FASB issued ASU No. 2016-10, Revenue from Contracts with Customers (Topic 606): Identifying Performance Obligations and Licensing, which clarifies the guidance in ASU No. 2014-09 regarding assessing whether promises to transfer goods or services are distinct, and whether an entity's promise to grant a license provides a customer with a right to use, or right to access the entity's intellectual property. In May 2016, the FASB issued ASU 2016-12 "Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients (Topic 606)", which clarifies the guidance on assessing collectability, presenting sales taxes, measuring noncash consideration, and certain transition matters. All standards are effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2017, and interim periods within that reporting period. The Company is currently evaluating the impact of the amended revenue recognition standard on its consolidated financial statements.

In March 2016, the FASB issued ASU 2016-09, Improvements to Employee Share-Based Payment Accounting, which involves several aspects of the accounting for stock-based payment transactions, including the income tax consequences, classification of awards as either equity or liabilities, and classification on the statement of cash flows. This new guidance will require all income tax effects of awards to be recognized as income tax expense or benefit in the income statement when the awards vest or are settled, as opposed to additional paid-in-capital where it is currently recorded. It also will allow an employer to repurchase more of an employee’s shares than it can today for tax withholding purposes without triggering liability accounting. All tax-related cash flows resulting from stock-based payments are to be reported as operating activities on the statement of cash flows. The guidance also allows a Company to make a policy election to either estimate the number of awards that are expected to vest or account for forfeitures as they occur. This new standard is effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2016, with early adoption permitted. The Company is currently evaluating the impact that this standard will have on its consolidated financial statements.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of certain cash receipts and cash payments, which addresses the following eight specific cash flow issues: Debt prepayment or debt extinguishment costs; settlement of zero-coupon debt instruments or other debt instruments with coupon interest rates that are insignificant in relation to the effective interest rate of the borrowing; contingent consideration payments made after a business combination; proceeds from the settlement of insurance claims; proceeds from the settlement of corporate-owned life insurance policies (including bank-owned life insurance policies); distributions received from equity method investees; beneficial interests in securitization transactions; and separately identifiable cash flows and application of the predominance principle. The new standard is effective for annual reporting periods, and interim periods within those periods, beginning after December 15, 2017, with early adoption permitted. The Company does not anticipate that the adoption of ASU 2016-15 will have a material impact on its consolidated financial statements.

Instruments Recorded at Fair Value on a Recurring Basis

The Company has segregated all financial assets and liabilities that are measured at fair value on a recurring basis (at least annually) into the most appropriate level within the fair value hierarchy based on the inputs used to determine the fair value at the measurement date in the table below.

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Assets and liabilities measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015 are as follows (in thousands):

The Company’s investments in Level 1 assets are valued based on publicly available quoted market prices for identical securities as of September 30, 2016 and December 31, 2015.

The warrant liability is recorded at fair value using the Black-Scholes option pricing model based on the following assumptions as of September 30, 2016 and December 31, 2015:

The assumptions were determined as follows:

Assumed risk-free interest rate — Based on the average yield of U.S. Treasury bills as of the valuation date for the expected term of the award.

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Assumed volatility — Based on the historical volatility of a number of publicly traded companies comparable in size, business model, industry and business description.

Expected life — Based on the remaining contractual term of warrant as of the valuation date.

Expected dividend yield — Based upon the Company’s historic dividends and dividend expectations for the foreseeable future.

Preferred stock fair value — On September 30, 2016, the Company was in the process of pricing its common stock for sale to the public and the midpoint of the pricing range was $15.00.  As all preferred stock would immediately convert to common stock upon the consummation of the IPO, the Company used $15.00 as it represented the preferred stock fair value as of September 30, 2016. Given the absence of a public trading market on December 31, 2015, the Company considered numerous objective and subjective factors to determine the fair value of preferred stock at each valuation date. These factors included, but were not limited to, (i) contemporaneous valuations of preferred stock performed by unrelated third-party specialists; (ii) the prices for preferred stock sold to outside investors; (iii) the rights, preferences and privileges of preferred stock relative to common stock; (iv) developments in the business; and (v) the likelihood of achieving a liquidity event, such as an IPO or a merger or acquisition of the Company, given prevailing market conditions.

As of September 30, 2016 and December 31, 2015, reasonable changes in the unobservable inputs would not be expected to have a significant impact on the consolidated financial statements. The Company’s policy is to recognize transfers between levels of the fair value hierarchy on the date of the event or change in circumstances that caused the transfer. There were no significant transfers into or out of Level 1, 2, or 3 for the nine months ended September 30, 2016 and the year ended December 31, 2015.

The following table provides reconciliation for all liabilities measured at fair value using significant unobservable inputs (Level 3) for the nine months ended September 30, 2016 and the year ended December 31, 2016 (in thousands):

Instruments Not Recorded at Fair Value on a Recurring Basis

The estimated fair value of long-term debt is determined by Level 2 inputs and is based primarily on quoted market prices for the same or similar issues. The recorded value of long-term debt approximates the current fair value based the Second Amendment to the Loan and Security Agreement, or the 2016 Loan Agreement, entered into with Pacific Western Bank in September 2016.

The following table sets forth the computation of basic and diluted net loss per share of common stock (in thousands, except for shares and per share data):

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The following table sets forth the outstanding potentially dilutive securities determined using the treasury stock and if-converted methods that have been excluded in the calculation of diluted net loss per share because to do so would be anti-dilutive (in common stock equivalent shares):

Short-term investments consist of the following (in thousands):

Inventory consist of the following (in thousands):

Other current assets consist of the following (in thousands):

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

Depreciation and amortization expense was $0.1 million for both the nine months ended September 30, 2016 and 2015.

Other current liabilities consist of the following (in thousands):

In June 2013, the Company entered into a loan and security agreement, or 2013 Loan Agreement, with Square 1 Bank allowing for borrowings up to $3.0 million. In addition to the interest payments, Square 1 Bank received warrants for the purchase of up to 8,693 shares of the Company’s Series C-1 convertible preferred stock. In October 2014, the Company amended the 2013 Loan Agreement and executed a $10.0 million credit facility with Square 1 Bank, or 2014 Loan Agreement. The 2014 Loan Agreement was separated into two tranches, Term Loan A and Term Loan B. Term Loan A was $5.0 million, which included the existing $3.0 million of outstanding debt and the additional $2.0 million that was funded upon closing of the 2014 Loan Agreement. Term Loan B was $5.0 million and was available upon receipt of at least $20.0 million in proceeds from the issuance and sale of the Company’s equity securities to investors. Term Loan B was funded after the close of the Company’s Series D financing in January 2015. As part of the 2014 Loan Agreement, the Company issued Square 1 Bank additional warrants to purchase up to 27,869 shares of its Series D convertible preferred stock at $7.5351 per share.

The present value of the future cash flows under the 2014 Loan Agreement terms did not exceed the present value of the future cash flows under the 2013 Loan Agreement terms by more than 10%. As such, the Company treated this amendment as a modification and recorded the associated immaterial facility fee and the associated immaterial fair value of the warrants as a discount to the 2014 Loan Agreement. This discount and the remaining balance of debt issuance costs and debt discount of the 2013 Loan Agreement were amortized to interest expense over the remaining term of the 2014 Loan Agreement using the effective-interest method.

On September 7, 2016, the Company entered into the 2016 Loan Agreement, with Pacific Western Bank (as successor in interest to Square 1 Bank), which amends the existing outstanding debt agreement described above. The 2016 Loan Agreement allows for total borrowings up to $15.0 million in two tranches as follows: a first tranche consisting of $10.0 million funded on September 7, 2016, of which the full $10.0 million must be used to repay the existing debt with Pacific Western Bank on a net settlement basis (pursuant to its original terms); and a second tranche consisting of an additional $5.0 million which may be drawn at any time prior to March 7, 2017. The first tranche and the second tranche are collectively referred to as the “Term Loans.” The Term Loans bear interest at the greater of prime rate plus 1.50% per annum, or 5.00%. The Term Loans mature on September 7, 2020 and have an interest-only period through March 2018 followed by 30 equal monthly installments of principal and interest. The Term Loans may be prepaid in full at any time with no additional cost.

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The present value of the future cash flows under the 2016 Loan  Agreement did not exceed the present value of the future cash flows under the 2014 Loan Agreement terms by more than 10%. As such, the Company treated the 2016 Loan Agreement as a modification and recorded the associated immaterial facility fee as a discount to the 2016 Loan Agreement. This discount and the remaining balance of debt issuance costs and debt discount of the 2014 Loan Agreement are amortized to interest expense over the remaining term of the 2016 Loan Agreement using the effective-interest method.

Pursuant to the 2016 Loan Agreement, the Company issued to Pacific Western Bank a warrant to purchase a number of the Company’s Series E Preferred Stock, at a purchase price of $8.2932 per share, equal to 3.0% of the total amount of up to $5.0 million of debt drawn over $10.0 million divided by the purchase price, which automatically converted into a warrant to purchase the same number of shares of common stock immediately prior to the closing of the Company’s IPO, and will only be exercisable in the event that the Company borrows all or part of the second tranche. As the Company has not drawn down on the second tranche, none of these warrants are exercisable as of September 30, 2016.

The 2016 Loan Agreement also requires that, if the Company’s total cash is less than $15.0 million, the Company is required to maintain all its deposits, transaction accounts and primary investment accounts with Pacific Western Bank, and if the Company’s total cash is greater than $15.0 million, it is required to maintain 50% of its deposits, transaction accounts and primary investment accounts with Pacific Western Bank. In addition, should the Company draw on the second tranche and its cash balance fall below $5.0 million, the Company is required to deliver a signed term sheet to Pacific Western Bank that is reasonably acceptable to the bank for the sale of the Company’s equity securities.

Total long-term loan and unamortized debt discount balances are as follows (in thousands):

As of September 30, 2016, future principal payments due under the 2016 Loan Agreement are as follows (in thousands):

The Company adopted an Equity Incentive Plan, or the Plan, in 2008, under which 2,380,074 shares of common stock are reserved for issuance to employees, nonemployee directors, and consultants of the Company. The Plan provides for the grant of incentive stock options, nonstatutory stock options, rights to purchase restricted stock, stock appreciation rights, dividend equivalents, stock payments, and restricted stock units to eligible recipients.

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The fair value of stock options for employees was estimated using a Black-Scholes option pricing model with the following assumptions:

The Company recognized stock-based compensation straight-line over the vesting term of the options. The Company recorded non-cash compensation, including non-cash compensation to employees and nonemployees in the condensed consolidated statements of operations and comprehensive loss as follows (in thousands):

Unrecognized compensation expense at September 30, 2016 was approximately $0.8 million, which is expected to be recognized over a weighted-average term of 3.3 years.

Equity instruments issued to nonemployees are initially recorded at their grant-date fair value and are periodically revalued using the Black-Scholes Option Pricing model as the equity instruments vest and are recognized as expense over the related service period. Stock-based compensation expense to nonemployees was immaterial for the nine months ended September 30, 2016 and 2015.

The following table summarizes stock option transactions for the Plan for the nine months ended September 30, 2016 (in thousands, except shares and per share data):

All options outstanding are exercisable under the early exercise provisions of the Plan. Options granted under the Plan that are exercised prior to vesting are subject to repurchase by the Company at the original issue price and will vest according to the respective option agreement. For the nine months ended September 30, 2016, 252,453 options were early exercised and 246,927 remain unvested as of September 30, 2016 with a related liability of $0.3 million recorded under other current liabilities on the Company’s condensed consolidated balance sheet as of September 30, 2016.

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Convertible Preferred Stock

Convertible preferred stock consisted of the following (in thousands, except for shares):

Outstanding Warrants

The following warrants were outstanding as of September 30, 2016:

Series E Preferred Stock

On April 29, 2016, the Company completed its Series E financing. The Company sold 1,916,425 shares of Series E stock at $8.2932 per share for cash proceeds of $15.8 million, gross of $0.1 million in issuance costs. The holders of Series E stock are entitled to receive dividends, if declared, at a rate of $0.6635 per annum. In the event of liquidation, the holders of Series E shares are entitled to receive liquidation preferences at the rate of $8.2932 per share. Each share of Series E stock is convertible to one share of common stock immediately upon (i) the Company’s sale of its common stock in a firm commitment underwritten public offering pursuant to a registration statement under the Securities Act of 1933, as amended, in which per share price is at least $12.44 (as adjusted) or (ii) the affirmative vote of more than 67% of the holders of the then-outstanding preferred stock voting together as a single class.

The convertible preferred stock has been classified as temporary equity in the accompanying condensed consolidated balance sheets as the shares include provisions allowing the holder to cause redemption of the shares upon certain changes in control events that are outside of the Company’s control.

Amendments to Certificate of Incorporation

On April 29, 2016, the Company amended its amended and restated certificate of incorporation to:

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On October 12, 2016, the Company’s certificate of incorporation was further amended in connection with the closing of the IPO.  See Note 12 for further detail.

Common Stock Reserved for Future Issuance

Common stock reserved for future issuance consists of the following at September 30, 2016:

For the nine months ended September 30, 2016 and 2015, the Company did not record an income tax provision. The U.S. federal and California deferred tax assets generated from the Company’s net operating losses have been fully reserved, as the Company believes it is not more likely than not the benefit will be realized.

The Company leases facilities under a noncancelable operating lease that expires on March 31, 2017. Under the terms of the facilities lease, the Company is required to pay its proportionate share of property taxes, insurance and normal maintenance costs.

Future noncancelable minimum payment obligations under the operating lease were as follows as of September 30, 2016 (in thousands):

Rent expense was $0.2 million for both nine months ended September 30, 2016 and 2015, respectively.

In June 2013, the Company and Bader Sultan & Bros. Co W.L.L., or Bader, a healthcare products distributor based in Sufat, Kuwait, entered into a distribution agreement, whereby the Company appointed Bader as a distributor of its products. Sales to Bader began in November 2013. The Company’s agreement with Bader restricts Bader’s ability to sell competing products and requires Bader to purchase a certain number of products from the Company monthly based on annual forecasts that the Company provides to Bader. If Bader does not resell the minimum purchase quantity specified in the contract by the applicable date, then the Company has the right, in its sole discretion, to sell to other distributors in the Middle East or terminate its agreement with Bader. The initial term of the agreement expires in December 2019, and will thereafter automatically renew for successive terms of 12 months, subject to certain exceptions. The agreement can be terminated by the Company immediately upon certain breaches by Bader, or by either Bader or the Company for uncured material breach of the agreement.

As part of the 2014 Series D convertible preferred stock financing, Bader purchased 875,903 shares of the Company’s Series D convertible preferred stock. All terms of the purchase of preferred stock were the same for Bader as the other investors. Sales to Bader for the nine months ended September 30, 2016 totaled $2.6 million, which represent 100% of total revenue for the period. As of September 30, 2016, the Company had accounts receivable from Bader of $0.5 million.

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In January 2015, the Company and Bader amended the distribution agreement. In accordance with the amendment, Bader provided the Company with a deposit of $1.3 million, and committed to minimum product purchases for calendar year 2015. Under the terms of the amendment, the Company reserved the right to keep the deposit as liquidated damages if Bader did not meet the minimum product purchases. The Company classified the deposit as a current liability at December 31, 2015 on the consolidated balance sheets as the minimum product purchase levels were met. In April 2016, the Company and Bader entered into a Payment Direction Letter, resulting in the exchange of the distribution agreement deposit for 154,585 shares Series E convertible preferred stock at a price of $8.2932 per share.

Initial Public Offering

In connection with the IPO discussed in Note 1, the following events occurred:

Adoption of 2016 Equity Incentive Plan

On October 4, 2016, the 2016 Plan became effective. The 2016 Plan serves as a successor to the 2008 Plan. The 2016 Plan permits the award of stock options, restricted stock awards, stock appreciation rights, restricted stock units, performance awards, cash awards and stock bonuses. The Company reserved 2,200,000 shares of common stock for issuance under the 2016 Plan, plus the 223,271 reserved and unissued shares under the 2008 plan on the effective date of the 2016 Plan. The number of shares reserved for issuance under the 2016 Plan will increase automatically on January 1 of each calendar year continuing through the tenth calendar year during the term of the 2016 Plan by the number of shares equal to 4% of the total outstanding shares of our common stock and common stock equivalents as of the immediately preceding December 31.

Adoption of 2016 Employee Stock Purchase Plan

On October 5, 2016, the 2016 ESPP became effective. The 2016 ESPP was adopted in order to enable eligible employees to purchase shares of the Company’s common stock at a discount. Purchases will be accomplished through participation in discrete offering periods.  The Company initially reserved 180,000 shares of common stock for issuance under the 2016 ESPP. The number of shares reserved for issuance under the 2016 ESPP will increase automatically on January 1 of each calendar year beginning after the first offering date and continuing through the first ten calendar years by the number of shares equal to 1% of the total outstanding shares of our common stock and common stock equivalents as of the immediately preceding December 31.

Warrant Exercises

On October 10, 2016, warrants for 36,562 shares of the Company's common stock were exercised by Pacific Western Bank via cashless exercise resulting in the issuance of 16,558 shares of common stock.  

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This Quarterly Report on Form 10-Q contains forward-looking statements. All statements other than statements of historical fact are “forward-looking statements” for purposes of this Quarterly Report on Form 10-Q. These forward-looking statements may include, but are not limited to, statements regarding our future results of operations and financial position, business strategy, market size, potential growth opportunities, timing and results of preclinical and clinical development activities, and potential regulatory approval and commercialization of products and product candidates. In some cases, forward looking-statements may be identified by terminology such as “believe,” “may,” “will,” “should”, “predict”, “goal”, “strategy”, “potentially,” “estimate,” “continue,” “anticipate,” “intend,” “could,” “would,” “project,” “plan,” “expect,” “seek” and similar expressions and variations thereof. These words are intended to identify forward-looking statements.

We have based these forward-looking statements largely on our current expectations and projections about future events and trends that we believe may affect our financial condition, results of operations, business strategy, research and development, short-term and long-term business operations and objectives and financial needs. These forward-looking statements are subject to a number of risks, uncertainties and assumptions, including those described in the “Risk Factors” section and elsewhere in this Quarterly Report on Form 10-Q. Moreover, we operate in a very competitive and rapidly changing environment, and 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. In light of these risks, uncertainties and assumptions, the forward-looking events and circumstances discussed in this Quarterly Report on Form 10-Q may not occur and actual results could differ materially and adversely from those anticipated or implied in the forward-looking statements.

You should not rely upon forward-looking statements as predictions of future events. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee that the future results, levels of activity, performance or events and circumstances reflected in the forward-looking statements will be achieved or occur. We undertake no obligation to update publicly any forward-looking statements for any reason after the date of this report to conform these statements to actual results or to changes in our expectations, except as required by law.

As used in this Quarterly Report on Form 10-Q, the terms “Obalon,” “the Company,” “we,” “us,” and “our” refer to Obalon Therapeutics, Inc. and, where appropriate, its consolidated subsidiary, unless the context indicates otherwise.

You should read the following discussion and analysis of our financial condition and results of operations together with our unaudited condensed consolidated financial statements and related notes included in Part I, Item 1 of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and related notes thereto for the year ended December 31, 2015, included in our prospectus dated October 5, 2016, filed with the Securities and Exchange Commission, or SEC, on October 6, 2016 pursuant to Rule 424(b)(4) under the Securities Act of 1933, as amended, or the Prospectus.

OVERVIEW

We are a commercial-stage medical device company focused on developing and commercializing innovative medical devices to treat obese and overweight people. Our initial product offering is the Obalon balloon system, the first and only U.S. Food and Drug Administration, or FDA approved swallowable, gas-filled intragastric balloon designed to provide progressive and sustained weight loss in obese patients. In September 2016, we received premarket approval from the FDA, to market our balloon system for temporary use to facilitate weight loss in obese adults with a body mass index, or BMI, of 30 to 40, who have failed to lose weight through diet and exercise. The Obalon balloon system is intended to be used as an adjunct to a moderate intensity diet and behavior modification program. The Obalon balloon system has the potential to provide patients and physicians with a cost-effective, reversible and repeatable weight loss solution in an outpatient setting, without altering patient anatomy or requiring surgery. We anticipate commencing the U.S. commercial launch of our Obalon balloon system in early 2017. As of September 30, 2016, we had sold over 25,000 of our earlier generation Obalon balloon systems for commercial use outside the United States.

We began selling an earlier version of our Obalon balloon system in international markets in the third quarter of 2012. In 2015, we discontinued sales in certain international markets to conserve financial resources.  We continued distribution of our earlier generation product in the Middle East while we focused on developing our current Obalon balloon system for both the US and international markets. In 2017, we intend to discontinue international distribution of our earlier generation product and begin selling our current Obalon balloon system.

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In June 2013, we entered into a distribution agreement with Bader Sultan & Bros. Co W.L.L., or Bader, a healthcare products distributor based in Sufat, Kuwait, which subsequently became one of our significant stockholders. Pursuant to the distribution agreement, in November 2013, we began selling our earlier generation Obalon balloon system to Bader, our sole distributor in the Middle East. Sales to Bader for the nine months ended September 30, 2016 and 2015 totaled $2.6 million and $2.8 million, which represented 100% and 92.7% of total revenue, respectively. As of September 30, 2016, all of our total revenue consisted of sales of our earlier generation Obalon balloon system to Bader. We expect Bader to account for a significantly lower percentage of our total revenue as we commence commercial sales in the United States in 2017.

We intend to focus our sales and marketing efforts primarily on selling our product in the United States through a direct sales force, as well as selling our products through Bader in the Middle East and other distributors in select international markets. We are building a direct sales organization consisting of regional sales directors, executive account managers and product specialists. We initially plan to sell the Obalon balloon system on a self-pay basis into existing physician specialty areas with weight loss practices, such as bariatric surgeons and gastroenterologists. In addition, we are targeting plastic surgeons, as we believe they have experience managing self-pay and cash pay practices. Given the initial focus of our sales and marketing efforts, we are targeting the U.S. market with a sales organization of approximately 20 to 25 individuals.

We generated total revenue, including revenue recognized from related parties, of $0.8 million and $1.1 million for the three months ended September 30, 2016 and 2015, respectively and $2.6 million and $3.1 million for the nine months ended September 30, 2016 and 2015, respectively. For the nine months ended September 30, 2016 and 2015, our net loss was $13.0 million and $10.7 million, respectively. We have not been profitable since inception, and as of September 30, 2016, our accumulated deficit was $69.1 million. From inception through September 30, 2016, we financed our operations primarily through private placements of our preferred securities and, to a lesser extent, debt financing arrangements.

On October 5, 2016, our Registration Statement on Form S-1/A (File No. 333-213551) relating to the IPO of our common stock was declared effective by the SEC. Pursuant to such Registration Statement, we sold an aggregate of 5,000,000 shares of our common stock at a price of $15.00 per share for aggregate cash proceeds of approximately $67.4 million, net of underwriting discounts, commissions, and estimated offering costs. The sale of 5,000,000 shares in the IPO closed on October 12, 2016.

We expect to continue to incur net losses for the foreseeable future as we commercialize our product in the United States, including building our sales and marketing organization and expanding our manufacturing facilities, continue research and development efforts, and seek regulatory approval for new products and product enhancements. We may need additional funding to pay expenses relating to our operating activities, including selling, general and administrative expenses and research and development expenses. Adequate funding, if needed, may not be available to us on acceptable terms, or at all. Our failure to obtain sufficient funds on acceptable terms could have a material adverse effect on our business, results of operations or financial condition.

COMPONENTS OF OUR RESULTS OF OPERATIONS

Revenue

Total revenue consists of international sales of an earlier generation of our Obalon balloon system. Revenue consists of sales of our Obalon balloon system to distributors or directly to physicians in international markets outside of the Middle East, and revenue, related party reflects sales of our Obalon balloon system to Bader in the Middle East. During the third quarter of 2015, we discontinued sales in international markets other than the Middle East, and for the nine months ended September 30, 2016, total revenue consisted of sales of our Obalon balloon system to Bader in the Middle East.

We plan to focus on selling our Obalon balloon system in the United States, which we anticipate will be our primary market. We expect that, as a result, total revenue will increase as we implement our U.S. sales strategy and our revenue from international sales will constitute a smaller percentage of total revenue. However, the degree to which our revenue increases depends on many factors, including acceptance of our Obalon balloon system by doctors and patients, the emergence of competing products and general economic trends.

Cost of revenue and gross margin

Cost of revenue consists primarily of costs related to the direct materials and direct labor that are used to manufacture our products and the manufacturing overhead that directly supports manufacturing. Currently, a significant portion of our cost of revenue consists of manufacturing overhead, which is mostly fixed in nature. These overhead costs include the costs of compensation for operations supervision and management, material procurement, inventory control, facilities and depreciation on production equipment. We expect cost of revenue to increase in absolute dollars to the extent our total revenue grows but decrease as a percentage total of revenue over time as our revenue increases and the fixed portion of our overhead costs is allocated over a greater number of units.

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We calculate gross margin as gross profit divided by total revenue. Our gross margin has been and will continue to be affected by a variety of factors, primarily production volumes, manufacturing costs, product yields, headcount and cost-reduction strategies. We expect our gross margin to increase over the long term as our production volume increases and as we allocate the fixed portion of our manufacturing overhead costs over a larger number of units produced, thereby reducing our per unit manufacturing costs. We intend to use our design, engineering and manufacturing capabilities to further advance and improve the efficiency of our manufacturing processes, which we believe will reduce costs and increase our gross margin. While we expect gross margin to increase over the long term, it will likely fluctuate from quarter to quarter as we continue to introduce new products and adopt new manufacturing processes and technologies.

Research and development expenses

Research and development, or R&D, expenses consist of the cost of engineering, clinical affairs, regulatory affairs and quality assurance associated with developing our Obalon balloon system. R&D expenses consist primarily of:

We expense R&D costs as incurred. In the future, we expect R&D expenses to increase in absolute dollars as we continue to develop new products and enhance existing products and technologies. However, we expect R&D expenses as a percentage of total revenue to vary over time depending on the level and timing of our new product development efforts, as well as our clinical development, clinical trial and other related activities.

Selling, general and administrative expenses

Selling, general and administrative, or SG&A, expenses consist of employee-related expenses, including salaries, benefits, travel expense and stock-based compensation expense. Other SG&A expenses include promotional activities, marketing, conferences and trade shows, professional services fees, including legal, audit and tax fees, insurance costs, general corporate expenses and allocated facilities-related expenses. We have grown our sales and marketing force significantly in the recent quarter in preparation for the commercial launch of our Obalon balloon system in the United States in early 2017. As a result, SG&A expenses have grown significantly in the recent quarter, and are expected to continue to increase in absolute dollars and as a percentage of total revenue for the foreseeable future as we continue to expand our sales and marketing infrastructure to drive and support anticipated growth in revenue and due to the additional legal, accounting, insurance and other expenses associated with becoming a public company.

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RESULTS OF OPERATIONS

Comparison of three months ended September 30, 2016 and 2015

Total revenue.    Total revenue decreased $0.3 million to $0.8 million during the three months ended September 30, 2016, compared to $1.1 million during the three months ended September 30, 2015. This decrease was primarily attributable to a decrease in the volume of balloon units sold in the Middle East, which was partially offset by an increase in the price per unit sold.

Cost of revenue.    Cost of revenue remained consistent at $0.6 million during the three months ended September 30, 2016. This was primarily attributable to a decrease in volume sold, offset by expenses related to our FDA’s premarket approval of our product, including employee related expenses and a write down of obsolete material associated with our earlier generation product.

Research and development expenses.    R&D expenses decreased $1.0 million to $2.2 million during the three months ended September 30, 2016, compared to $3.2 million during the three months ended September 30, 2015. This decrease was primarily attributable to a $1.3 million decrease in clinical trial expenses due to the conclusion of our SMART trial. This decrease was partially offset by a $0.3 million increase in employee-related expenses associated with additional headcount and bonus expenses relating to FDA’s premarket approval of our product.

Selling, general and administrative expenses.    SG&A expenses increased $1.8 million to $2.4 million during the three months ended September 30, 2016, compared to $0.6 million during the three months ended September 30, 2015. This increase was primarily attributable to a $0.7 million increase in legal fees associated with increased intellectual property development and protection, $0.6 million increase in employee-related expenses from an increase in headcount, and a $0.5 million increase in outside consultants expense associated with sales and marketing activities in preparation for commercialization in the United States.

Interest expense, net.    Interest expense, net remained relatively consistent at $0.1 million for the three months ended September 30, 2015 and 2016.

Comparison of nine months ended September 30, 2016 and 2015

Total revenue.    Total revenue decreased $0.5 million to $2.6 million during the nine months ended September 30, 2016, compared to $3.1 million during the nine months ended September 30, 2015. This decrease was primarily attributable to a decrease in the volume sold as we discontinued sales of our previous generation product in international markets outside the Middle East beginning in the third quarter of 2015 and reduced the volume sold in the Middle East in preparation for transition to our current generation product in 2017, which was partially offset by an increase in the price per unit sold.

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Cost of revenue.    Cost of revenue increased $0.1 million to $1.9 million during the nine months ended September 30, 2016, compared to $1.8 million during the nine months ended September 30, 2015. This increase was primarily attributable to increased payroll costs and changes in the allocation of production cost between R&D expense and cost of revenue. Cost of revenue was also impacted by approximately $0.1 million of expenses related to FDA’s premarket approval of our product, including a bonus accrual relating to such approval, and a write down of obsolete material associated with our earlier generation product.

Research and development expenses.    R&D expenses decreased $1.9 million to $7.3 million during the nine months ended September 30, 2016, compared to $9.2 million during the nine months ended September 30, 2015. This decrease was primarily attributable to a $2.8 million decrease in clinical trial expenses due to the conclusion of our SMART trial. This decrease was partially offset by a $0.7 million increase in employee-related expenses associated with additional headcount and a $0.2 million increase due to outside consultants expenses associated with projects to prepare us for FDA audits during the nine months ended September 30, 2016.

Selling, general and administrative expenses.    SG&A expenses increased $3.1 million to $5.4 million during the nine months ended September 30, 2016, compared to $2.3 million during the nine months ended September 30, 2015. This increase was primarily attributable to a $1.7 million increase in legal fees associated with increased intellectual property development and protection, a $0.7 million increase in employee-related expenses from an increase in headcount and a $0.7 million  increase in outside consultants expenses associated with sales and marketing activities in preparation for commercialization in the United States.

Interest expense, net.    Interest expense, net remained consistent at $0.4 million for the nine months ended September 30, 2016 and 2015.

LIQUIDITY AND CAPITAL RESOURCES

As of September 30, 2016, we had cash and cash equivalents and short-term investments of $14.2 million and an accumulated deficit of $69.1 million. Our primary sources of capital have been private placements of preferred stock and the incurrence of debt. To date, we have raised an aggregate of $70.5 million in proceeds from convertible preferred stock financings. Additionally, in June 2013, we incurred $3.0 million of debt under a loan and security agreement with Square 1 Bank, which was amended in October 2014 to increase the outstanding debt to $5.0 million with an additional $5.0 million funded in January 2015. In September 2016, the loan and security agreement was subsequently amended to provide for an additional $5.0 million in funding, which we may borrow at any time prior to March 7, 2017. As of September 30, 2016, our aggregate outstanding indebtedness under the loan and security agreement was $10.0 million.

On October 5, 2016, our Registration Statement on Form S-1/ A (File No. 333-213551) relating to the IPO of our common stock was declared effective by the SEC. Pursuant to such Registration Statement, we sold an aggregate of 5,000,000 shares of our common stock at a price of $15.00 per share for aggregate cash proceeds of approximately $67.4 million, net of underwriting discounts, commissions, and estimated offering costs. The sale of 5,000,000 shares in the IPO closed on October 6, 2016.

Due to the FDA’s recent approval of our Obalon balloon system, we expect to incur substantial additional expenditures in the next 12 months to support the commercial launch of our product in the Unites States beginning in early 2017. We believe that the net proceeds from our IPO, together with our existing cash and cash equivalents and short-term investments and expected revenue, will be sufficient to meet our capital requirements and fund our operations through the next two years. We expect our costs and expenses to increase in the future as we prepare for and commence U.S. commercialization of our Obalon balloon system, including the development of a direct sales force and the expansion of our manufacturing facilities, and as we continue to make substantial expenditures on research and development, including for conducting clinical trials of our products in development. Additionally, we expect to incur additional costs as a result of operating as a public company. Our future capital requirements will depend on many factors, including:

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Additional financing, if necessary, may not be available on a timely basis on terms acceptable to us, or at all. We may raise funds in equity or debt financings following our IPO or enter into additional credit facilities in order to access funds for our capital needs. If we raise additional funds through further issuances of equity or convertible debt securities, our existing stockholders could suffer significant dilution in their percentage ownership of our company, and any new equity securities we issue could have rights, preferences and privileges senior to those of holders of our common stock. Any debt financing obtained by us in the future would cause us to incur additional debt service expenses and could include restrictive covenants relating to our capital raising activities and other financial and operational matters, which may make it more difficult for us to obtain additional capital and pursue business opportunities. If we are unable to obtain adequate financing or financing on terms satisfactory to us when we require it, we may terminate or delay the development of one or more of our products, delay clinical trials necessary to market our products, or delay establishment or expansion of sales and marketing capabilities or other activities necessary to commercialize our products.

Loan and security agreement

In June 2013, we entered into a $3.0 million loan and security agreement with Square 1 Bank (predecessor in interest to Pacific Western Bank), which we subsequently amended in October 2014 and September 2016.

As of September 30, 2016, we could borrow up to $15.0 million in two tranches as follows: a first tranche consisting of $10.0 million which was carried over from our previous agreement in September 2016, and a second tranche of $5.0 million which may be drawn by us any time prior to May 7, 2017. As of September 30, 2016, we have not drawn down on this second tranche, and had $10.0 million outstanding under this loan and security agreement, which has a variable annual interest rate equal to the greater of the prime rate plus 1.50% or 5.0%, and matures in September 2020.

The loan and security agreement provides for an interest-only period through March 2018, followed by a 30-month principal and interest period. Pursuant to the loan and security agreement, we provided a first priority security interest in all existing and after-acquired assets, excluding intellectual property, owned by us.

Pursuant to the loan and security agreement, we issued to Pacific Western Bank a warrant to purchase a number of our shares of Series E convertible preferred stock, at a purchase price of $8.2932 per share, equal to 3.0% of the total amount of debt drawn under the second tranche divided by the purchase price, which automatically converted into a warrant to purchase the same number of shares of common stock immediately prior to the closing of our IPO, and will only be exercisable in the event that we borrow all or part of the second tranche.

The loan and security agreement provides for restrictions on, among other things, our ability to incur additional indebtedness, change the name or location of our business, change our business, merge with or acquire other entities, pay dividends or make other distributions to holders of our capital stock, make certain investments, engage in transactions with our affiliates, create liens, sell assets, pay any subordinated debt, and store certain inventory and equipment with third parties. In addition, if our total cash is less than $15.0 million, we are required to maintain all our deposits, transaction accounts and primary investment accounts with Pacific Western Bank, and if our total cash is greater than $15.0 million, we are required to maintain 50% of our deposits, transaction accounts and primary investment accounts with Pacific Western Bank.

CASH FLOWS

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Net cash used in operating activities

During the nine months ended September 30, 2016, net cash used in operating activities was $13.6 million, consisting primarily of a net loss of $13.0 million and an increase in net operating assets of $1.7 million, primarily related to deferred offering costs incurred during the quarter ended September 30, 2016.  These items were partially offset by non-cash charges of $1.1 million, consisting primarily of changes in the fair value of warrant liability, share-based compensation expense, depreciation and non-cash interest expense related to amortization of investment premium and debt discount.

During the nine months ended September 30, 2015, net cash used in operating activities was $7.2 million, consisting primarily of a net loss of $10.7 million, partially offset by a decrease in net operating assets of $3.0 million and non-cash charges of $0.6 million. The decrease in net operating assets consisted primarily of an increase in accrued expenses for our SMART trial and a customer deposit received from Bader. The non-cash charges primarily consisted of share-based compensation expense, depreciation and non-cash interest expense related to amortization of investment premium and debt discount.

Net cash used in investing activities

During the nine months ended September 30, 2016, net cash used in investing activities was $3.0 million, consisting primarily of purchases of short-term investments, partially offset by maturities of short-term investments.

During the nine months ended September 30, 2015, net cash used in investing activities was $3.1 million, consisting primarily of purchases of short-term investments, partially offset by maturities of short-term investments.

Net cash provided by financing activities

During the nine months ended September 30, 2016, net cash provided by financing activities was $15.6 million, consisting of net proceeds of $14.5 million from the issuance of Series E convertible preferred stock and proceeds of $1.1 million from sale of common stock.

During the nine months ended September 30, 2015, net cash provided by financing activities was $5.1 million, consisting primarily of proceeds of $5.0 million from borrowings under our loan and security agreement with Pacific Western Bank.

OFF-BALANCE SHEET ARRANGEMENTS

We currently have no off-balance sheet arrangements, such as structured finance, special purpose entities or variable interest entities.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

Our management’s discussion and analysis of our financial condition and results of operations is based on our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles, or U.S. GAAP. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value 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 that the accounting policies related to revenue recognition, accrued research and development costs, stock-based compensation expense and income taxes are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates.

There have been no significant changes in our critical accounting policies and estimates as compared to the critical accounting policies and estimates disclosed in Management’s Discussion and Analysis of Financial Condition and Operations included in the Prospectus, except for the determination of the fair value of our common stock, which was used in estimating the fair value of stock-based awards at grant date. Prior to our IPO, our stock was not publicly traded, therefore we estimated the fair value of our common stock as discussed in the Prospectus. Following our IPO, we established a policy, using the closing sale price per share of our common stock as quoted on the NASDAQ Global Market on the date of grant, for purposes of determining the exercise price per share of our share-based awards to purchase common stock.

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RECENT ACCOUNTING PRONOUNCEMENTS

Except as described in Note 2 to the Unaudited Interim Condensed Consolidated Financial Statements under the heading “Recent Accounting Pronouncements,” there have been no new accounting pronouncements or changes to accounting pronouncements during the three and nine months ended September 30, 2016, as compared to the recent accounting pronouncements described in the Prospectus that are of significance or potential significance to us.

JOBS ACT ACCOUNTING ELECTION

In April 2012, the JOBS Act was enacted. Section 107 of the JOBS Act provides that an emerging growth company can take advantage of an extended transition period for complying with new or revised accounting standards. Thus, an emerging growth company can delay the adoption of certain accounting standards until those standards would otherwise apply to private companies. We have elected not to avail ourselves of this extended transition period and, as a result, we will adopt new or revised accounting standards on the relevant dates on which adoption of such standards is required for other public companies.

INTEREST RATE RISK

The risk associated with fluctuating interest rates is primarily limited to our cash equivalents and short-term investments, which are carried at quoted market prices. All of our short-term investments are U.S. treasury notes with maturities of less than one year. Due to the short-term maturities and low risk profile of our cash equivalents and short-term investments, an immediate 100 basis point change in interest rates would not have a material effect on the fair value of our cash equivalents. We do not currently use or plan to use financial derivatives in our investment portfolio.

In addition, we have outstanding debt under our loan and security agreement with Pacific Western Bank that bears interest. As of September 30, 2016, our aggregate outstanding indebtedness was $10.0 million, which bears interest at the rate equal to the greater of the prime rate plus 1.50% or 5.0%. We do not believe an immediate 10% increase in interest rates would have a material effect on interest expense for the loan with Pacific Western Bank, and therefore we do not expect our operating results or cash flows to be materially affected to any degree by a sudden change in market interest rates.

CREDIT RISK

As of December 31, 2015 and September 30, 2016, our cash and cash equivalents were maintained with one financial institution in the United States, and our current deposits are likely in excess of insured limits. We have reviewed the financial statements of this institution and believe it has sufficient assets and liquidity to conduct its operations in the ordinary course of business with little or no credit risk to us.

EFFECTS OF INFLATION

We do not believe that inflation and changing prices had a significant impact on our results of operations for any periods presented herein.

Evaluation of Disclosure Controls and Procedures

Our management, with the participation of our principal executive officer and our principal financial officer, evaluated, as of the end of the period covered by this Quarterly Report on Form 10-Q, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended, or the Exchange Act). Based on that evaluation, our principal executive officer and principal financial officer have concluded that as of September 30, 2016, our disclosure controls and procedures were effective at the reasonable assurance level. Management recognizes that any controls and procedures, no matter how well designed  and operated, can provide only reasonable assurance of achieving their objectives and our management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Changes in Internal Control over Financial Reporting

There were no changes in our internal control over financial reporting identified in connection with the evaluation required by Rule 13a-15(d) and 15d-15(d) of the Exchange Act that occurred during the quarter ended September 30, 2016 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II-OTHER INFORMATION

From time to time, we are involved in legal proceedings in the ordinary course of business. We are currently not a party to any legal proceedings that we believe would have a material adverse effect on our business, financial condition or results of operations.

Investing in our common stock involves a high degree of risk. Before making your decision to invest in shares of our common stock, you should carefully consider the risks described below, together with the other information contained in this Quarterly Report on Form 10-Q, including our unaudited interim condensed consolidated financial statements and the related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” The risks and uncertainties described below are not the only ones we face. Additional risks and uncertainties that we are unaware of, or that we currently believe are not material, may also become important factors that affect us. If any of the following risks actually occurs, our business, financial condition, results of operations and future growth prospects could be materially and adversely affected. In that event, the market price of our common stock would likely decline, and you could lost all or part of your investment.

RISKS RELATED TO OUR BUSINESS

We have limited operating experience and a history of net losses, and we may not be able to achieve or sustain profitability.

We have a limited operating history and have focused primarily on research and development, clinical trials, product engineering and building our manufacturing capabilities. We have also conducted a commercial launch of a previous generation of the Obalon balloon system in certain international markets, but our commercial sales experience in these international markets has been limited and our total revenue to date is approximately $11.4 million. We have incurred significant losses in each period since our inception in 2008, with net losses of $5.3 million and $13.0 million for the three and nine months ended September 30, 2016, respectively and of $3.6 million and $10.7 million for the three and nine months ended September 30, 2015, respectively. As of September 30, 2016, we had an accumulated deficit of approximately $69.1 million. These losses and our accumulated deficit reflect the substantial investments we have made to develop, seek and obtain regulatory approval for our Obalon balloon system and sell our Obalon balloon system internationally.

We expect our costs and expenses to increase in the future as we prepare for and commence U.S. commercialization of our product, including the development of a direct sales force and the expansion of our manufacturing facilities, and as we continue to expend substantial amounts on research and development, including for conducting clinical trials, of our products in development. As a result, we expect our losses to continue for the foreseeable future. In addition, as a public company, we will incur significant legal, accounting and other expenses that we did not incur as a private company. Accordingly, we cannot assure you that we will achieve profitability in the future or that, if we do become profitable, we will sustain profitability. Our failure to achieve and sustain profitability would negatively impact the market price of our common stock.

We are currently a single product company with limited commercial sales experience, which makes it difficult to evaluate our current business, predict our future prospects and forecast our financial performance and growth.

We were incorporated in 2008, and to date our business activities have been focused primarily on the development and regulatory approval of our Obalon balloon system. All of our revenue to date is, and we expect for the foreseeable future will be, attributable to sales of our Obalon balloon system and its component parts. Our commercial sales experience to date has been limited to sales to distributors in a limited number of countries outside the United States. We recently obtained premarket approval, or PMA, from the U.S. Food and Drug Administration, or FDA, to market the current generation of our balloon system in the United States, and we expect that sales in the United States will account for a majority of our revenue for the foreseeable future. Our limited operating experience and lack of commercialization experience in what we expect will be our primary market make it difficult to evaluate our current business and predict our future prospects. A number of factors that are outside our control may contribute to fluctuations in our financial results, including:

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It is therefore difficult to predict our future financial performance and growth, and such forecasts are inherently limited and subject to a number of uncertainties. If our assumptions regarding the risks and uncertainties we face, which we use to plan our business, are incorrect or change due to circumstances in our business or our markets, or if we do not address these risks successfully, our operating and financial results could differ materially from our expectations and our business could suffer.

Because we devote substantially all of our resources to our Obalon balloon system and rely on our Obalon balloon system as our sole source of revenue, any factors that negatively impact our product, or result in decreasing product sales, would materially and adversely affect our business, financial condition and results of operations.

Physicians and patients may be slow to adopt and use intragastric balloons, and adverse events or other negative developments involving other companies’ intragastric balloons or other obesity treatments may further slow physician and patient adoption. If any of these events were to occur, our business and prospects would be negatively affected.

Intragastric balloons are a new treatment option for obese and overweight patients. Currently, we are aware of only two other intragastric balloons available for sale in the United States, neither of which was available prior to 2015. As a result, physician and patient awareness of intragastric balloons as a treatment option for obesity and weight management, and experience with intragastric balloons, is minimal. Our success depends in large part on our ability to educate physicians and patients, and successfully demonstrate the safety, tolerability, ease of use, efficacy, cost effectiveness and other merits of our Obalon balloon system. Since we received PMA approval for the Obalon balloon system in September 2016, we expect to begin engaging in an active marketing campaign to raise awareness of our Obalon balloon system and its benefits among physicians, but we cannot assure you that these efforts will be successful or that they will not prove to be cost-prohibitive.

Physicians play a significant role in determining the course of a patient’s weight management or obesity treatments and as a result, the type of treatment that will be recommended or provided to a patient. We intend to target our sales efforts at bariatric surgeons and gastroenterologists, and, over time, to plastic surgeons, because they are either the physicians treating obese and overweight patients and/or have experience with endoscopic procedures. However, the initial point of contact for many obese and overweight patients may be general practitioners, bariatricians, endocrinologists, obstetricians and gynecologists, each of whom commonly manage and regularly see patients that are obese or overweight. If these physicians are not made aware of our Obalon balloon system, they may not refer patients to bariatric surgeons, gastroenterologists or plastic surgeons for treatment using our product, and those patients may instead not seek treatment at all or be treated with pharmaceuticals or an alternative device or surgical procedure.

Additionally, because the market for intragastric balloons is new and developing and contains a limited number of market participants, our products could be negatively impacted by unfavorable market reactions to these other devices. If the use of these or future intragastric balloons results in serious adverse device events, or SADEs, or such products are subject to malfunctions or misuse, patients and physicians may attribute such negative events to intragastric balloons generally, which may adversely affect market adoption of our Obalon balloon system. Additionally, if patients undergoing treatment with our Obalon balloon perceive the weight loss inadequate or adverse events too numerous or severe as compared with the retreatment rates of alternative balloons or procedures, it will be difficult to demonstrate the value of our Obalon balloon system to patients and physicians. As a result, demand for our Obalon balloon system may decline or may not increase at the pace or to the levels we expect.

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If we are unable to convince physicians to adopt our Obalon balloon system and recommend it to their patients, we may be unable to sell our products, grow our business or achieve profitability.

Our ability to sell our Obalon balloon system depends heavily on the willingness of physicians to adopt our system and recommend it to their patients. Physicians may not adopt our Obalon balloon system unless they are able to determine, based on experience, long-term clinical data, recommendations from other physicians and published peer-reviewed journal articles, that it provides a safe and effective treatment alternative for obesity. Even if we are able to raise awareness among physicians, physicians tend to be slow in changing their medical treatment practices and may be hesitant to select our Obalon balloon system for recommendation to patients for a variety of reasons, including:

We are also aware of certain characteristics and features of our Obalon balloon system that may prevent widespread market adoption. For example, our Obalon balloon system is approved as an adjunct to a moderate intensity diet and behavior modification program. As a result, physicians will need to develop the appropriate practice management programs, which include treatment protocols, nutritional counseling and patient management, to treat patients in a manner consistent with our treatment protocol. If physicians are unable or unwilling to implement the appropriate practice management programs to successfully treat patients with the Obalon balloon, they may not adopt our balloon system. Our current EzFill inflation system requires certain pre-programming that is dependent upon the altitude of the physician’s practice, which may hinder or make it more difficult for us to market and commercialize our products.

The effectiveness and safety of our Obalon balloon system depends critically on our ability to educate physicians on its safe and proper use. If we are unable to do so, we may not achieve our expected growth and may be subject to risks and liabilities.

In addition to educating physicians on the clinical benefits of our Obalon balloon system, we must also train physicians on its safe and appropriate use. In particular, our FDA approved labeling requires physicians to complete an Obalon training program before they can place the device and for us to provide clinical support as needed. If we are unable to provide an adequate training program, product misuse may occur that could lead to SADEs. Many physicians may be unfamiliar with such treatments or find it more complex than competitive products or alternative treatments. As such, there is a learning process involved for physicians to become proficient in the use of our products and it may take several procedures for a physician to be able to use our Obalon balloon system comfortably. In addition, it is also critical for physicians to be educated and trained on best practices in order to achieve optimal results, including patient selection and eligibility criteria as well as complementary methods of use such as diet or behavioral modification programs. Convincing physicians to dedicate the time and energy necessary for adequate training is challenging, and we cannot assure you that we will be successful in these efforts. This training process may also take longer than we expect. In the event that physicians are not properly trained in the use of our Obalon balloon system, they may misuse or ineffectively use our products for the treatment of patients. As a result, patients may experience adverse events or not be able to enjoy the benefits of our system or achieve the weight loss outcomes they expect, leading to dissatisfaction and market rejection of our products. In addition, misuse of our products in any stage of the treatment may result in, among other things, patient injury, adverse side effects, negative publicity or lawsuits against us. Any of these events could have an adverse effect on our business and reputation.

If patients are unable to successfully swallow the capsule, our device malfunctions during delivery or physicians cannot deploy the Obalon balloon, physicians may be unwilling to continue to recommend our products.

Patients may be unable to successfully swallow the capsule that contains the Obalon balloon, potentially creating an economic disincentive for physicians in adopting our technology. In our SMART trial, 7.6% of the combined treatment and control group patients failed to swallow a capsule with the microcatheter attached despite success swallowing a placebo that did not have a catheter attached. There were also instances where balloon deployment was negatively impacted due to a leak in the microcatheter, which was caused by the patient biting the catheter during placement. There may be other reasons for unsuccessful placements that we are not yet aware. If the balloon is not successfully placed for any reason, the patient may attempt to seek a refund or monetary damages for the

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treatment. Alternatively, physicians that have paid us for a balloon, but have not been paid by their patient because of a treatment failure, may seek a refund or monetary damages from us. Either scenario could cause a negative financial impact for us and could also create ill will with patients and physicians.

Patients may experience SADEs as the result of the misuse or malfunction of, or design flaws in, our products, which could expose us to expensive litigation, divert management’s attention and harm our reputation and business.

Our business is subject to significant risks associated with manufacture, distribution and use of medical devices that are placed inside the human body, including the risk that patients may be severely injured by or even die from the misuse or malfunction of our products caused by design flaws or manufacturing defects. In addition, our business may suffer adverse consequences even in circumstances where a patient injury is caused by the actions of others, such as where a patient is injured due to the improper or negligent use of our products by a physician.

For instance, if the Obalon capsule does not reach a patient’s stomach and is inflated in another portion of the body, such as the esophagus, the patient could experience a serious injury. A patient who experiences an esophageal inflation of the balloon would most likely require surgical intervention, and could die as a result of an esophageal inflation or as a result of complications from the subsequent intervention. Serious injury could also occur if one or more of the balloons deflates and migrates into the lower intestine causing an obstruction.   This can also lead to surgical removal of the device and associated complications including death.  Esophageal perforation leading to sepsis and death associated with the sepsis has been reported with use of our product.  Balloon deflation and migration into the lower intestine requiring surgical removal has also been reported with use of our product. While we have designed our products, and established instructions and protocols for physicians, to attempt to mitigate such risks, we cannot guarantee that adverse events will not occur again in the future. For example, physicians have in the past failed may again in the future fail to follow our instructions and protocols, and the safety systems we design into our products may not prevent all possible adverse events and injuries and/or our products may fail to function properly.