SWK Holdings Corp - Quarter Report: 2015 June (Form 10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

SWK Holdings Corporation

(Exact Name of Registrant as Specified in its Charter)

(972) 687-7250 (Registrant’s Telephone Number, Including Area Code)

Securities registered pursuant to Section 12(b) of the Act: None

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

Common Stock, $0.001 par value per share

(Title of class)

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.    x  YES    o  NO

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    o   YES    x  NO

As of August 12, 2015, there were 131,176,153 shares of the registrant’s Common Stock, $0.001 par value per share, outstanding.

SWK Holdings Corporation

Form 10-Q

Quarter Ended June 30, 2015

Table of Contents

FORWARD-LOOKING STATEMENTS

In addition to historical information, this report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. From time to time, we may also provide oral or written forward-looking statements in other materials we release to the public. Such forward looking statements are subject to the safe harbor created by the Private Securities Litigation Reform Act of 1995. The forward-looking statements are not historical facts but rather are based on current expectations, estimates and projections about our business and industry, and our beliefs and assumptions, and include, but are not limited to, statements under the headings “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and Outlook. Words such as “anticipate,” “believe,” “estimate,” “expects,” “intend,” “plan,” “will” and variations of these words and similar expressions identify forward-looking statements. These statements are not guarantees of future performance and are subject to risks, uncertainties and other factors, many of which are beyond our control, are difficult to predict and could cause actual results to differ materially (both favorable and unfavorably) from those expressed or forecasted in the forward-looking statements. These risks and uncertainties include, but are not limited to, those described in “Risk Factors” and elsewhere in this report, and those described from time to time in our past and future reports filed with the Securities and Exchange Commission, including in our Annual Report on Form 10-K for the year ended December 31, 2014. Forward-looking statements that were believed to be true at the time made may ultimately prove to be incorrect or false. We undertake no obligation to revise or publicly release the results of any revision to these forward-looking statements. Given these risks and uncertainties, readers are cautioned not to place undue reliance on such forward-looking statements.

PART I. FINANCIAL INFORMATION

ITEM I.              FINANCIAL STATEMENTS

SWK HOLDINGS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

See accompanying notes to the unaudited condensed consolidated financial statements.

SWK HOLDINGS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF INCOME (LOSS)

(in thousands, except per share data)

See accompanying notes to the unaudited condensed consolidated financial statements.

SWK HOLDINGS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands, except per share data)

See accompanying notes to the unaudited condensed consolidated financial statements.

SWK HOLDINGS CORPORATION

UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

Supplementary noncash flow activity:

See accompanying notes to the unaudited condensed consolidated financial statements.

NOTES TO THE UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

Note 1. SWK Holdings Corporation and Summary of Significant Accounting Policies

Nature of Operations

SWK Holdings Corporation (the “Company,” “SWK,” “we,” “us,” or “our”) was incorporated in July 1996 in California and reincorporated in Delaware in September 1999. In July 2012, the Company commenced its strategy of building a specialty finance and asset management business. The Company’s strategy is to be a leading healthcare capital provider by offering sophisticated, customized financing solutions to a broad range of life science companies, institutions and inventors. The Company has initially focused on monetizing cash flow streams derived from commercial-stage products and related intellectual property through royalty purchases and financings, as well as through the creation of synthetic revenue interests in commercialized products. The Company has been deploying its assets to earn interest, fees, and other income pursuant to this strategy, and the Company continues to identify and review financing and similar opportunities on an ongoing basis.

As of June 30, 2015, the Company had executed 18 transactions under its specialty finance strategy, funding approximately $158,100,100 in various financial products across the life science sector. The Company’s portfolio includes senior and subordinated debt backed by royalties and synthetic royalties paid by companies in the life science sector, purchased royalties generated by sales of life science products and related intellectual property and an unconsolidated equity investment in a company which retains the marketing authorization rights to a pharmaceutical product.

The Company is headquartered in Dallas, Texas.

Basis of Presentation

The Company’s unaudited condensed consolidated financial statements are prepared in accordance with accounting principles generally accepted in the United States (“GAAP”).  The unaudited condensed consolidated financial statements include the accounts of all subsidiaries and affiliates in which the Company holds a controlling financial interest as of the financial statement date. Normally a controlling financial interest reflects ownership of a majority of the voting interests. The Company consolidates a variable interest entity (“VIE”) when it possesses both the power to direct the activities of the VIE that most significantly impact its economic performance and the Company is either obligated to absorb the losses that could potentially be significant to the VIE or the Company holds the right to receive benefits from the VIE that could potentially be significant to the VIE, after elimination of intercompany accounts and transactions.

The Company owns interests in various partnerships and limited liability companies, or LLCs.  The Company consolidates its investments in these partnerships or LLCs, where the Company, as the general partner or managing member, exercises effective control, even though the Company’s ownership is less than 50%.  The related governing agreements provide the Company with broad powers, and the other parties do not participate in the management of the entity and do not have the substantial ability to remove the Company.  The Company has reviewed each of the underlying agreements to determine if it has effective control.  If circumstances changed and it was determined this control did not exist, this investment would be recorded using the equity method of accounting.  Although this would change individual line items within the Company’s condensed consolidated financial statements, it would have no effect on our net income and/or total stockholders’ equity attributable to the Company.

The Company operates in one operating segment with a single management team that reports to the chief executive officer, who is the Company’s chief operating decision maker.

Unaudited Interim Financial Information

The unaudited condensed consolidated financial statements have been prepared by the Company and reflect all normal, recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the interim financial information. The results of operations for the interim periods presented are not necessarily indicative of the results to be expected for any subsequent quarter or for the year ending December 31, 2015. Certain information and footnote disclosures normally included in financial statements prepared in accordance with GAAP have been condensed or omitted under the rules and regulations of the Securities and Exchange Commission (“SEC”). These unaudited condensed consolidated financial statements and notes included herein should be read in conjunction with the audited consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 27, 2015.

Use of Estimates

The preparation of the Company’s unaudited condensed consolidated financial statements in conformity with GAAP requires the Company to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the unaudited condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Significant estimates and assumptions are required in the determination of revenue recognition, stock-based compensation, impairment of financing receivables and long-lived assets, valuation of warrants, income taxes and contingencies and litigation, among others.  Some of these judgments can be subjective and complex, and, consequently, actual results may differ from these estimates. The Company estimates often are based on complex judgments, probabilities and assumptions that it believes to be reasonable but that are inherently uncertain and unpredictable. For any given individual estimate or assumption made by the Company, there may also be other estimates or assumptions that are reasonable.

The Company regularly evaluates its estimates and assumptions using historical experience and other factors, including the economic environment. As future events and their effects cannot be determined with precision, the Company’s estimates and assumptions may prove to be incomplete or inaccurate, or unanticipated events and circumstances may occur that might cause us to change those estimates and assumptions. Market conditions, such as illiquid credit markets, volatile equity markets, and economic downturn, can increase the uncertainty already inherent in the Company’s estimates and assumptions. The Company adjusts its estimates and assumptions when facts and circumstances indicate the need for change. Those changes generally will be reflected in our condensed consolidated financial statements on a prospective basis unless they are required to be treated retrospectively under the relevant accounting standard. It is possible that other professionals, applying reasonable judgment to the same facts and circumstances, could develop and support a range of alternative estimated amounts.

Reclassification

Certain amounts have been reclassified in the presentation of the financial statements as of December 31, 2014, and for the three and six months ended June 30, 2014, to be consistent with the presentation in the financial statements as of June 30, 2015 and for the three and six months ended June 30, 2015. This reclassification had no impact on previously reported net income, cash flow from operations or changes in stockholder deficit.

Recent Accounting Pronouncements

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) 2014-09, “Revenue from Contracts with Customers (Topic 606),” which is the new comprehensive revenue recognition standard that will supersede all existing revenue recognition guidance under U.S. GAAP. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to a customer in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. This ASU is effective for annual reporting periods beginning after December 15, 2017 and interim reporting periods within that reporting period. Early adoption is not permitted. Accordingly, the Company will adopt this ASU on January 1, 2018. Companies may use either a full retrospective or a modified retrospective approach to adopt this ASU. The Company is currently evaluating the impact of ASU 2014-09 on the Company’s consolidated financial statements.

In February 2015, the FASB issued ASU 2015-02, “Consolidation (Topic 810): Amendments to the Consolidation Analysis,” which makes changes to both the variable interest model and voting interest model and eliminates the indefinite deferral of FASB Statement No. 167, included in ASU 2010-10, for certain investment funds. All reporting entities that hold a variable interest in other legal entities will need to re-evaluate their consolidation conclusions as well as disclosure requirements. This ASU is effective for annual periods beginning after December 15, 2015, and early adoption is permitted, including any interim period. The Company is currently evaluating the impact of adopting this guidance.

In April 2015, the FASB issued ASU 2015-03, “Interest - Imputation of Interest (Subtopic 835-30): Simplifying the Presentation of Debt Issuance Costs,” which requires debt issuance costs be presented in the balance sheet as a direct deduction from the carrying value of the associated debt liability, and amortization of those costs should be reported as interest expense. This ASU is effective for financial statements issued for annual and interim periods beginning after December 15, 2015, and early adoption is permitted for financial statements that have not been previously issued. The new guidance should be applied on a retrospective basis for each period presented in the balance sheet. The Company is currently evaluating the impact of adopting this guidance.

Note 2. Net Income (Loss) per Share

Basic net income (loss) per share is computed using the weighted average number of outstanding shares of common stock. Diluted net income (loss) per share is computed using the weighted average number of outstanding shares of common stock and, when dilutive, shares of common stock issuable upon exercise of options and warrants deemed outstanding using the treasury stock method.

The following table shows the computation of basic and diluted earnings (loss) per share for the following (in thousands, except per share amounts):

For the three month periods ended June 30, 2015 and 2014, outstanding stock options and warrants to purchase shares of common stock in an aggregate of approximately 4.8 million and 4.2 million, respectively, have been excluded from the calculation of diluted net income (loss) per share as all such securities were anti-dilutive. For the six month periods ended June 30, 2015 and 2014, outstanding stock options and warrants to purchase shares of common stock in an aggregate of approximately 4.8 million and 4.2 million, respectively, have been excluded from the calculation of diluted net income (loss) per share as all such securities were anti-dilutive.

Note 3. Finance Receivables

Finance receivables are reported at their determined principal balances net of any unearned income, cumulative charge-offs and unamortized deferred fees and costs. Unearned income and deferred fees and costs are amortized to interest income based on all cash flows expected using the effective interest method.

The carrying value of finance receivables are as follows (in thousands):

The Company originates finance receivables to companies primarily in the life sciences sector. This concentration of credit exposes the Company to a higher degree of risk associated with this sector.

On a quarterly basis, the Company evaluates the carrying value of each finance receivable for impairment. A term loan is considered to be impaired when, based on current information and events, it is determined that the Company will not be able to collect the amounts due according to the loan contract, including scheduled interest payments. This evaluation is generally based on delinquency information, an assessment of the borrower’s financial condition and the adequacy of collateral, if any. The Company would generally place term loans on nonaccrual status when the full and timely collection of interest or principal becomes uncertain and they are 90 days past due for interest or principal, unless the term loan is both well-secured and in the process of collection. When placed on nonaccrual, the Company would reverse any accrued unpaid interest receivable against interest income and amortization of any net deferred fees is suspended. Generally, the Company would return a term loan to accrual status when all delinquent interest and principal become current under the terms of the credit agreement and collectability of remaining principal and interest is no longer doubtful. In certain circumstances, the Company may place a finance receivable on nonaccrual status but conclude it is not impaired.

Receivables associated with royalty stream purchases would be considered to be impaired when it is probable that the Company will be unable to collect the book value of the remaining investment based upon adverse changes in the estimated underlying royalty stream.

When the Company identifies a finance receivable as impaired, it measures the impairment based on the present value of expected future cash flows, discounted at the receivable’s effective interest rate, or the estimated fair value of the collateral, less estimated costs to sell. If it is determined that the value of an impaired receivable is less than the recorded investment, the Company would recognize impairment with a charge to the allowance for credit losses. When the value of the impaired receivable is calculated by discounting expected cash flows, interest income would be recognized using the receivable’s effective interest rate over the remaining life of the receivable.

The Company would individually develop the allowance for credit losses for any identified impaired loans if any existed. In developing the allowance for credit losses, the Company would consider, among other things, the following credit quality indicators:

The following tables present a summary of the activity in the allowance for credit losses by portfolio segment for the six months ended June 30, 2015, (in thousands):

There was no provision for credit losses during the six months ended June 30, 2014, and no allowance for credit losses outstanding as of December 31, 2014.

The following table presents our nonaccrual and performing loans by portfolio segment (in thousands):

 As of June 30, 2015, the Company had two term loans in non-accrual status with a carry value of approximately $17,231,000. As of December 31, 2014, the Company had one loan in non-accrual status with a carry value of $5,969,000. Total cash collected on non-accrual loans for the six months ended June 30, 2015 was $184,500, which was credited to the respective loans’ carry value. Of the two non-accrual term loans at June 30, 2015, one was identified as impaired. The collateral dependent loan was individually reviewed, noting that the fair market value of the loan, less costs to sell, was lower than the recorded investment of the loan. As such, the Company recorded a provision for credit loss of $2,594,000. There were no loans considered impaired where a provision for credit loss was charged as of December 31, 2014.

Note 4. Marketable Investments

Investment in securities at June 30, 2015, and December 31, 2014, consist of the following (in thousands):

The amortized cost basis amount, gross unrealized holding gains (losses) and fair value of the available-for-sale security as of June 30, 2015 are as follows (in thousands):

The amortized cost basis amount, gross unrealized holding gains (losses) and fair value of the available-for-sale security as of December 31, 2014 are as follows (in thousands):

During the six months ended June 30, 2015, and the year ended December 31, 2014, the Company had no sales of available-for-sale securities and no securities have been considered impaired.

Note 5. Variable Interest Entities

The Company consolidates the activities of VIEs of which we are the primary beneficiary. The primary beneficiary of a VIE is the variable interest holder possessing a controlling financial interest through (i) its power to direct the activities of the VIE that most significantly impact the VIE’s economic performance and (ii) its obligation to absorb losses or its right to receive benefits from the VIE that could potentially be significant to the VIE. In order to determine whether the Company owns a variable interest in a VIE, the Company performs qualitative analysis of the entity’s design, organizational structure, primary decision makers and relevant agreements.

Consolidated VIE

SWK HP Holdings LP (“SWK HP”) 

SWK HP was formed in December 2012 to acquire a limited partnership interest in Holmdel Pharmaceuticals LP (“Holmdel”).   Holmdel acquired the U.S. marketing authorization rights to a beta blocker pharmaceutical product indicated for the treatment of hypertension for a total purchase price of $13,000,000. The Company, through its wholly owned subsidiary SWK Holdings GP LLC (“SWK Holdings GP”) acquired a direct general partnership interest in SWK HP, which in turn acquired a limited partnership interest in Holmdel. The total investment in SWK HP of $13,000,000 included $6,000,000 provided by SWK Holdings GP and $7,000,000 provided by non-controlling interests.   Subject to customary limited partner protections afforded the investors by the terms of the limited partnership agreement, the Company maintains voting and managerial control of SWK HP and therefore includes it in its consolidated financial statements.

SWK HP is considered a VIE due to the lack of voting or similar decision-making rights by its equity holders regarding activities that have a significant effect on the economic success of the partnership. The Company’s ownership in SWK HP constitutes variable interests. The Company has determined that it is the primary beneficiary of the SWK HP as (i) the Company has the power to direct the activities that most significantly impact the economic performance of SWK HP via its obligations to perform under the partnership agreement, and (ii) the Company has the right to receive residual returns that could potentially be significant to SWK HP. As a result, the Company consolidates SWK HP in its financial statements and the limited partner interests of SWK HP owned by third parties are reflected as a non-controlling interest in the Company’s unaudited condensed consolidated balance sheets.

Unconsolidated VIEs

Holmdel  

SWK HP has significant influence over the decisions made by Holmdel. SWK HP will receive quarterly distributions of cash flow generated by the pharmaceutical product according to a tiered scale that is subject to certain cash on cash returns received by SWK HP. Until SWK HP received a 1x cash on cash return on its interest in Holmdel, SWK HP received approximately 84% of the pharmaceutical product’s cash flow. As the cash on cash multiple received by SWK HP Holdings LP increases, SWK HP’s interest in the cash flow generated by the pharmaceutical product decreases, but in no instance will it decline below 39%. The current interest in the pharmaceutical product’s cash flow is approximately 70%. Holmdel is considered a VIE because SWK HP’s control over the partnership is disproportionate to its economic interest. This VIE remains unconsolidated as the power to direct the activities of the partnership is not held by the Company. The Company is using the equity method to account for this investment.   The Company accounts for its interest in the entity based on the timing of quarterly distributions, which are paid on a quarter lag basis. For the three and six months ended June 30, 2015, the Company recognized $1,339,000 and $2,890,000 of equity method gains, respectively. The amount of equity method gains attributable to the non-controlling interests in SWK HP were $678,000 and $1,489,000 for the three and six months ended June 30, 2015, respectively. For the three and six months ended June 30, 2014, the Company recognized $1,192,000 and $2,695,000 of equity method gains, respectively. The amount of equity method gains attributable to the non-controlling interests in SWK HP were $633,000 and $1,434,000 for the three and six months ended June 30, 2014, respectively.

In addition, SWK HP received cash distributions totaling $3,444,000 during the six months ended June 30, 2015, of which $1,787,000 was subsequently paid to holders of the non-controlling interests in SWK HP. Changes in the carrying amount of the Company’s investment in Holmdel for the six months ended June 30, 2015, are as follows (in thousands):  

The following table provides the financial statement information related to Holmdel for the comparative periods which SWK HP has reflected its share of Holmdel income in the Company’s unaudited condensed consolidated statements of income (loss):

Note 6. Loan Credit Agreement with Related Party

On September 6, 2013, the Company entered into a credit facility with Double Black Diamond, L.P. (the “Lender”), an affiliate of, Carlson Capital, L.P. (“Carlson”). Funds affiliated with Carlson (collectively, the “Stockholder”) are holders of a majority of the Company’s common stock. The credit facility provided financing for the Company, primarily for the purchase of eligible investments. The facility matures on September 6, 2017. The draw period under the facility expired on March 6, 2015, and as a result, as of June 30, 2015, the Company has no availability remaining on the facility. The Lender has received a security interest in basically all assets of the Company as collateral for the facility. In conjunction with the credit facility, the Company issued warrants to the Lender for 1,000,000 shares of the Company’s common stock at a strike price of $1.3875. The warrants have a price dilution mechanism that was triggered by the price that shares were sold in the Rights Offering in November 2014, and as a result, the strike price of the warrants was reduced to $1.348.

Due to certain provisions within the warrant agreement, the warrants meet the definition of a derivative and do not qualify for a scope exception as it is not considered indexed in the Company’s stock. As such, the warrants with a value of $616,000 and $421,000 at June 30, 2015, and December 31, 2014, respectively, are reflected as a warrant liability in the unaudited condensed consolidated balance sheets. Unrealized losses of $30,000 and $195,000 were included in other income (expense) in the unaudited condensed consolidated statements of income (loss) for the three and six months ended June 30, 2015, respectively. Unrealized losses of $66,000 and $24,000 were included in other income (expense) in the unaudited condensed consolidated statements of income for the three and six months ended June 30, 2014, respectively. The Company determined the fair value using the Black-Scholes option pricing model with the following assumptions:

During the three and six months ended June 30, 2015, the Company recognized interest expense totaling $0 and $381,000, respectively, consisting of debt issuance cost amortization. During the three and six months ended June 30, 2014, the Company recognized interest expense totaling $223,000 and $412,000, respectively. Interest expense included $36,000 and $71,000 of debt issuance cost amortization for the three and six months ended June 30, 2014, respectively. 

Note 7. Stockholders’ Equity

Stock Compensation

During the six months ending June 30, 2015, the Board approved the following grants as compensation for Board services: (i) a grant of 33,660 shares of common stock as the pro-rated director compensation for the non-employee directors appointed on September 6, 2014; (ii) a grant 20,000 shares to each non-employee directors for services as a director for the period January 1, 2015 to June 30, 2015; and (iii) a grant of 32,595 shares of common stock in lieu of cash payments to the non-employee directors upon the voluntary election of such directors. The Company recorded board compensation expense relating to the quarterly grants of approximately $68,000 and $107,000, respectively, during the three and six months ended June 30, 2015.

Non-controlling Interests

As discussed in Note 5, SWK HP has a limited partnership interest in Holmdel. Changes in the carrying amount of the non-controlling interest in the unaudited condensed consolidated balance sheet for the six months ended June 30, 2015, are as follows:  

Note 8. Fair Value Measurements

The Company measures and reports certain financial and non-financial assets and liabilities on a fair value basis. Fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). GAAP specifies a three-level hierarchy that is used when measuring and disclosing fair value. The fair value hierarchy gives the highest priority to quoted prices available in active markets (i.e., observable inputs) and the lowest priority to data lacking transparency (i.e., unobservable inputs). An instrument’s categorization within the fair value hierarchy is based on the lowest level of significant input to its valuation. The following is a description of the three hierarchy levels.

Transfers into or out of any hierarchy level are recognized at the end of the reporting period in which the transfers occurred. There were no transfers between any levels during the six months ended June 30, 2015 and 2014.

The fair value of equity method investments is not readily available nor have we estimated the fair value of these investments and disclosure is not required. The Company is not aware of any identified events or changes in circumstances that would have a significant adverse effect on the carrying value of any of our equity method investments included in their unaudited condensed consolidated balance sheets at June 30, 2015 or December 31, 2014.

Following are descriptions of the valuation methodologies used to measure material assets and liabilities at fair value and details of the valuation models, key inputs to those models and significant assumptions utilized.

Finance Receivables

The fair values of finance receivables are estimated using discounted cash flow analyses, using market rates at the balance sheet date that reflect the credit and interest rate-risk inherent in the finance receivables. Projected future cash flows are calculated based upon contractual maturity or call dates, projected repayments and prepayments of principal. These receivables are classified as Level 3. Finance receivables are not measured at fair value on a recurring basis, but estimates of fair value are reflected below.

Marketable Investments and Warrant Liability 

Debt securities 

If active market prices are available, fair value measurement is based on quoted active market prices and, accordingly, these securities would be classified as Level 1. If active market prices are not available, fair value measurement is based on observable inputs other than quoted prices included within Level 1, such as prices for similar assets or broker quotes utilizing observable inputs, and accordingly these securities would be classified as Level 2. If market prices are not available and there are no observable inputs, then fair value would be estimated by using valuation models including discounted cash flow methodologies, commonly used option-pricing models and broker quotes. Such securities would be classified as Level 3, if the valuation models and broker quotes are based on inputs that are unobservable in the market. If fair value is based on broker quotes, the Company checks the validity of received prices based on comparison to prices of other similar assets and market data such as relevant bench mark indices. Available-for-sale securities are measured at fair value on a recurring basis, while securities with no readily available fair market value are not, but estimates of fair value are reflected below.

Derivative securities 

For exchange-traded derivatives, fair value is based on quoted market prices, and accordingly, would be classified as Level 1. For non-exchange traded derivatives, fair value is based on option pricing models and are classified as Level 3.  

The following table presents financial assets and liabilities measured at fair value on a recurring basis as of June 30, 2015 (in thousands):

The following table presents financial assets and liabilities measured at fair value on a recurring basis as of December 31, 2014 (in thousands):

The changes on the value of the warrant assets during the six months ended June 30, 2015, were as follows (in thousands):

During the six months ended June 30, 2015, the Company wrote-off the entire value of the warrants associated with Response Genetics, Inc. (“Response”). Refer to Note 10, Subsequent Events for further information.  

The Company holds warrants issued to the Company in conjunction with certain term loan investments. These warrants meet the definition of a derivative and are included in the unaudited condensed consolidated balance sheets. The fair values for warrants outstanding, that have a readily determinable value, are measured using the Black-Scholes option pricing model. The following weighted average assumptions were used in the models to determine fair value:

The changes on the value of the warrant liability during the six months ended June 30, 2015, were as follows (in thousands):

For assets and liabilities measured on a non-recurring basis during the year, accounting guidance requires quantitative disclosures about the fair value measurements separately for each major category. There were no remeasured assets or liabilities at fair value on a non-recurring basis during the six months ended June 30, 2015 and December 31, 2014.

The following information, is provided to help readers gain an understanding of the relationship between amounts reported in the accompanying consolidated financial statements and the related market or fair value. The disclosures include financial instruments and derivative financial instruments, other than investment in affiliates (in thousands):

Note 9. Income Taxes

The Company recognizes interest and penalties related to uncertain tax positions as a component of income tax expense. The Company had no unrecognized tax benefits as of June 30, 2015, and December 31, 2014.

The Company will continue to assess the need for a valuation allowance on the deferred tax assets by evaluating both positive and negative evidence that may exist on a quarterly basis. Any adjustment to the deferred tax asset valuation allowance would be recorded in the unaudited condensed consolidated statements of income (loss) for the period that the adjustment is determined to be required.

Deferred tax assets consist of the following (in thousands):

The Tax Reform Act of 1986 limits the use of net operating loss and tax credit carryforwards in certain situations where stock ownership changes occur. In the event the Company has had a change in ownership, the future utilization of the Company’s net operating loss and tax credit carryforwards could be limited.

A portion of deferred tax assets relating to NOLs, pertains to NOL carryforwards resulting from tax deductions upon the exercise of employee stock options of approximately $1,800,000. When recognized, the tax benefit of these loss carryforwards will be accounted for as a credit to additional paid-in capital rather than a reduction of the income tax expense.

As of December 31, 2014, the Company had net operating loss carryforwards for federal income tax purposes of approximately $421,000,000. The federal net operating loss carryforwards, if not offset against future income, will expire by 2032, with the majority of such NOLs expiring by 2021.

Note 10. Subsequent Events

On August 10, 2015, Response filed a voluntary petition under Chapter 11 of the U.S. Bankruptcy Code. In connection with the filing, Response and Cancer Genetics, Inc. (“Cancer Genetics”) entered into an agreement pursuant to which Cancer Genetics will acquire substantially all of Response’s assets. The agreement constitutes a stalking horse bid and is subject to potential, competing bids through the approval process by the Delaware Bankruptcy Court. During the bankruptcy process, the Company will provide up to $3 million in debtor-in-possession financing (the “DIP financing”), to fund Response’s continued daily operations. The Company anticipates the sale will close in early October.

Based on the Company’s analysis of the fair value of Response’s net assets serving as collateral of the Company’s loan, as well as the costs anticipated to be incurred throughout the bankruptcy process, the Company determined that the loan outstanding at June 30, 2015, which had a carry value before any loss allowance of $10.6 million, was impaired and, as a result, the Company recognized loan impairment expense of $2.6 million. The unaudited condensed consolidated statement of income (loss) for the three and six months ended June 30, 2015, also includes a market valuation loss of $802,000 on outstanding warrants issued by Response to the Company. The respective warrant assets were valued at zero in the unaudited condensed consolidated balance sheet as of June 30, 2015.

ITEM 2.            MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

Management’s Discussion and Analysis of Financial Condition and Results of Operations (“MD&A”) is provided as a supplement to and should be read in conjunction with, our audited consolidated financial statements, and the MD&A included in our Annual Report on Form 10-K for the year ended December 31, 2014 (“Annual Report”), as well as our unaudited condensed consolidated financial statements and the accompanying notes include in this report.

Overview

We were incorporated in July 1996 in California and reincorporated in Delaware in September 1999.

In July 2012, we commenced our new corporate strategy of building a specialty finance and asset management business. Our strategy is to be a leading healthcare capital provider by offering sophisticated, customized financing solutions to a broad range of life science companies, institutions and inventors. We are currently focused on monetizing cash flow streams derived from commercial-stage products and related intellectual property through royalty purchases and financings, as well as through the creation of synthetic revenue interests in commercialized products. We deploy our assets to earn interest, fees, and other income pursuant to this strategy, and we continue to identify and review financing and similar opportunities on an ongoing basis. In addition, through our wholly-owned subsidiary, SWK Advisors LLC, we provide non-discretionary investment advisory services to institutional clients in separately managed accounts to similarly invest in life science finance. SWK Advisors LLC is registered as an investment advisor with the Texas State Securities Board. We intend to fund transactions through our own working capital, as well as by building our asset management business to invest additional third party capital alongside our capital.

We have NOLs and believe that the ability to utilize these NOLs is an important and substantial asset. We believe that the foregoing business strategies can create value for our stockholders, and produce prospective taxable income (or the ability to generate capital gains) that might permit us to utilize the NOLs. We are unable to assure investors that we will find suitable financing or other revenue generating opportunities or that we will be able to utilize our existing NOLs.

We intend to fill a niche that we believe is underserved in the sub-$50 million transaction size. Since many of our competitors that provide longer term, royalty-related financing options have much greater financial resources than us, they tend to not focus on transaction sizes below $50 million as it is generally inefficient for them to do so. In addition, we do not believe that a sufficient number of other companies offer similar types of long-term financing options to fill the demand of the sub-$50 million market. As such, we believe we face less competition from such longer term, royalty investors in transactions that are less than $50 million. 

We will evaluate and invest in a broad range of healthcare related companies and products with innovative intellectual property, including, the biotechnology, medical device, medical diagnostics and related tools, animal health and pharmaceutical industries (together “life science”) and to tailor our financial solutions to the needs of our business partners. Our business partners are primarily engaged in selling products that directly or indirectly cure diseases and/or improve people’s or animals’ wellness, or they receive royalties paid on the sales of such products. For example, our biotechnology and pharmaceutical business partners manufacture medication that directly treat disease states, whereas our life science tools partners sell a wide variety of research instrumentation to help other companies conduct research into disease states.

Our investment objective is to maximize our portfolio total return and thus increase our net income and net operating income by generating income from three sources:

1. primarily owning or financing through debt investments, royalties generated by the sales of life science products and related intellectual property;

2. to a lesser extent, receiving interest and other income by advancing capital in the form of secured debt to companies in the life science sector; and

3. to a lesser extent, realize capital appreciation from equity-related investments in the life science sector.

In our portfolio we seek to achieve attractive risk-adjusted current yields and opportunities with the potential for equity-like returns.

The majority of our transactions are expected to be structured similarly to factoring transactions whereby we provide capital in exchange for an interest in an existing revenue stream. The existing revenue stream can take several forms, but is most commonly either a royalty derived from the sales of a life science product (1) from the marketing efforts of a third party, such as a royalty paid to an inventor on the sales of a medicine or (2) from the marketing efforts of a partner company, such as a medical device company that directly sells its own products. Our structured debt investments may include warrants or other features, giving us the potential to realize enhanced returns on a portion of our portfolio. Capital that we provide directly to our partners is generally used for growth and general working capital purposes, as well as for acquisitions or recapitalizations in select cases. We generally fund the full amount of transactions up to $20 million through our working capital.  We do not anticipate providing capital in situations prior to the commercialization of a product.

Our investment advisory agreements are currently non-discretionary and each client determines individually if it wants to participate in a transaction. Each account receives its pro rata allocation for a transaction based on which clients opt into a transaction, and each account receives its pro rata allocation of income produced by a transaction in which they participate. Clients pay us management and incentive fees according to a written investment advisory agreement, and we negotiate fees based on each client’s needs and the complexity of the client’s requirements. Fees paid by clients may differ depending upon the terms negotiated with each client and are paid directly by the client upon receipt of an invoice from us. We may seek to gain access to additional discretionary capital from similar investors in the future.

In circumstances where a transaction is greater than $20 million, we seek to syndicate amounts in excess of $20 million to our investment advisory clients. In addition, we may participate in transactions in excess of $10 million with investors other than our investment advisory clients. In those instances, we do not expect to earn investment advisory income from the participations of such investors.

We source our investment opportunities through a combination of our senior management’s proprietary relationships within the industry, outbound business development efforts and inbound inquiry from companies, institutions and inventors interested in learning about our capital financing alternatives. Our investment advisory clients generally do not originate investment opportunities for us.

As of August 12, 2015, we have executed 18 transactions, deploying approximately $158,100,000 across a variety of opportunities:

In counting our transactions, we generally consider a series of transactions with one partner company as a single transaction. In six of the transactions, we participated alongside other investors; our investment advisory clients co-invested in two of these transactions. The other ten transactions were completed solely by SWK. Subsequent to closing on one of the eight transactions, however, we syndicated a portion of the loan to an investment advisory client and then subsequently purchased it back, and subsequently partnered with another investor on a follow-on round for the same partner company.

The table below provides an overview of the transactions.

Other than the $500,000 payable to the seller of the Cambia® royalty noted above, there are no other earn-out payments contracted to be paid by SWK to any of our partner companies. SWK has $9,500,000 of unfunded commitments on closed loan transactions.

Critical Accounting Policies and Estimates 

Our critical accounting policies and estimates are described in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 27, 2015. We believe there have been no new critical accounting policies or material changes to our existing critical accounting policies and estimates during the six months ended June 30, 2015, compared to those discussed in our Annual Report on Form 10-K for the year ended December 31, 2014.

Recent Accounting Pronouncements

Refer to Part I. Financial Information, Item I Financial Statements, Note 1 of the Notes for a listing of recent accounting pronouncements.

Revenues

We generated revenue of $5.4 million for the three months ended June 30, 2015, driven primarily by $4.1 million in interest and fees earned on our finance receivables, marketable securities and management fees, and $1.3 million in income related to our investment in an unconsolidated partnership. For the six months ended June 30, 2015, revenue totaled $11.2 and included $8.3 million in interest and fees earned on our finance receivables, marketable securities and management fees, and $2.9 million in income related to our investment in an unconsolidated partnership.

We generated revenue of $3.4 million for the three months ended June 30, 2014, driven primarily by $2.2 million in interest and fees earned on our finance receivables, marketable securities and management fees, and $1.2 million in income related to our investment in an unconsolidated partnership. We generated revenues of $7.0 million for the six months ended June 30, 2014, driven primarily by $4.3 million in interest and fees earned on our finance receivables, marketable securities and management fees, and $2.7 million in income related to our investment in an unconsolidated partnership.

The primary driver behind our increases in revenue is the continued deployment of capital, which increases our portfolio company investments.

Provision for credit losses

We recognized credit loss provision expense of $2.6 million, on a term loan based on the Company’s impairment analysis performed as of June 30, 2015. The secured loan’s carrying value has been reduced to its collateral’s fair market value, less costs to sell. See Note 10 of the Notes regarding the borrower filing for Chapter 11 bankruptcy protection after June 30, 2015.

General and Administrative Expenses

General and administrative expense consists primarily of employee compensation, stock-based compensation and related costs for employees, Board of Directors, legal and audit expenses, and corporate governance. General and administrative expense as a percentage of revenue was 17.5% for the three months ended June 30, 2015, compared to 22.1% for the three months ended June 30, 2014. For the six months ended June 30, 2015, general and administrative expense as a percentage of revenue was 19.3%, compared to 20.1% for the six months ended June 30, 2014.

Interest

For the three months ended June 30, 2015, there was no interest expense compared to $223,000 during the three months ended June 30, 2014, which related to the then outstanding loan agreement.

Interest expense for the six months ended June 30, 2015, was $381,000, reflecting the write-off of the remaining unamortized deferred issuance costs upon the expiration of the draw period under our credit agreement. Interest expense for the six months ended June 30, 2014, was $412,000 and included $341,000 of interest due on the loan agreement and $71,000 of deferred issuance costs amortization.

Other Income (Expense)

Other income (expense) for the three months ended June 30, 2015, reflecting a net fair market value loss of $1.6 million, on our warrant derivatives compared to a net fair market value gain of $219,000 during the three months ended June 30, 2014. Other income (expense) for the six months ended June 30, 2015, reflecting a net fair market value loss of $1.2 million, on our warrant derivatives compared to a net fair market value gain of $373,000 during the six months ended June 30, 2014.

Provision for Income Taxes

We have incurred net operating losses on a consolidated basis for all years from inception through 2012. Accordingly, we have historically recorded a valuation for the full amount of gross deferred tax assets, as the future realization of the tax benefit was not “currently more likely than not.” We believe that it is more likely than not that the Company will be able to realize approximately $18.6 million benefit of the U.S. federal and state deferred tax assets in the future.

As of December 31, 2014, we had NOLs for federal income tax purposes of approximately $421 million. The federal NOLs if not offset against future income, will expire by 2032, with the majority expiring by 2021. 

Liquidity and Capital Resources

As of June 30, 2015, we had $28.4 million in cash and cash equivalents compared to $58.7 million in cash and cash equivalents as of December 31, 2014. The reduction in cash is driven essentially by investing activities during the six months.

Primary Driver of Cash Flow

Our ability to generate cash in the future depends primarily upon our success in implementing our revised business model of generating income by providing capital to a broad range of life science companies, institutions and inventors. We generate income primarily from three sources:

As of August 12, 2015, we have consummated 18 transactions under our new strategy and expect those assets to generate income greater than our expenses in 2015. We continue to evaluate multiple attractive opportunities that, if consummated, would similarly generate additional income. Since the timing of any investment is difficult to predict, we may not be able to generate positive cash flow above what our existing assets will produce in 2015. Given low current interest rates, we expect the interest rate that we receive on our cash will continue to be at a low rate and to not produce material income.

Operating Cash Flow

Net cash provided by operating activities was $4.6 million for the six months ended June 30, 2015, and consisted primarily of net income of $3.4 million and $1.9 million noncash adjustments, partially offset by changes in net operating assets of $0.7 million. The noncash adjustments were primarily attributable to provision expense for loan credit losses of $2.6 million, $1.5 million deferred tax provision, a fair value net loss on warrant derivatives of $1.2 million, $0.4 million debt issuance cost and $0.3 million in stock compensation expense, partially offset by $2.9 million from equity income on an investment in an unconsolidated entity and $1.2 million in loan discount amortization, fee accretion and interest income collected in excess of cash received.

Net cash provided by operating activities was $2.4 million for the six months ended June 30, 2014 and consisted primarily of net income of $4.3 million partially offset by noncash adjustments of $2.1 million and changes in operating assets and liabilities of $0.2 million. The noncash adjustments were primarily attributable to $2.7 million from equity income on an investment in an unconsolidated entity, $0.5 million in loan discount amortization, fee accretion and interest income collected in excess of cash received and a fair value net gain on warrant derivatives of $0.4 million, offset by $1.3 million deferred tax provision and $0.1 million of stock-based compensation.

Investing Cash Flow

The Company’s investing activities provided negative cash flow of $33.1 million during the six months ended June 30, 2015, driven by a net issuance of $36.5 million in finance receivables, partially offset by $3.4 million in cash distributions received from an investment in an unconsolidated entity. The Company’s investing activities had positive cash flow of $1.6 million during the six months ended June 30, 2014, which primarily related to $3.5 million in cash distributions received from an investment in an unconsolidated entity, partially offset by our net issuance of $1.9 million in finance receivables.    

Financing Cash Flow

The Company’s financing activities had negative cash flow of $1.8 million for the six months ended June 30, 2015, which consisted primarily of cash distributions to non-controlling interests. The Company’s financing activities had positive cash flow of $4.1 million for the six months ended June 30, 2014, which consisted of $6.0 million in loan proceeds from our credit agreement, partially offset by $1.9 million in cash distributions to non-controlling interests.

Off-Balance-Sheet Arrangements

In the normal course of operations, we engage in a variety of financial transactions that, in accordance with GAAP, are not recorded in our financial statements. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.

The contractual amounts of commitments to extend credit represent the amounts of potential accounting loss should the contract be fully drawn upon, the customer defaults and the value of any existing collateral becomes worthless. We use the same credit policies in making commitments and conditional obligations as we do for on-balance sheet instruments. Other than the $.5 million payable to the seller of the Cambria® royalty, there no other earn-out payments contracted to be paid by us to any of our partner companies. We have approximately $9.5 million of unfunded commitments on closed loan transactions.

We believe that we will continue to have sufficient funds and alternative funding sources to meet our current commitments.

Outlook

Our corporate strategy is to provide capital to a broad range of life science companies, institutions and inventors in order to earn interest, fee, and other income pursuant to this strategy. As of August 12, 2015, we have consummated 18 transactions under our corporate strategy. We believe the income generated by these transactions will be more than our operational expenses, and we will begin to grow our book value going forward. We continue to evaluate multiple attractive opportunities that, if consummated, would similarly generate additional income. 

ITEM 3.            QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.

During the six months ended June 30, 2015, our cash and cash equivalents were deposited in accounts at well capitalized financial institutions. The fair value of our cash and cash equivalents at June 30, 2015, approximated its carrying value.

Investment and Interest Rate Risk

We are subject to financial market risks, including changes in interest rates. As we seek to provide capital to a broad range of life science companies, institutions and investors, our net investment income is dependent, in part, upon the difference between the rate at which we earn on our cash and cash equivalents and the rate at which we lend those funds to third parties. As a result, we would be subject to risks relating to changes in market interest rates. We may use interest rate risk management techniques in an effort to limit our exposure to interest rate fluctuations by providing capital at variable interest rates.  We constantly monitor our portfolio and position our portfolio to respond appropriately to a reduction in credit rating of any portfolio of products.

Inflation

We do not believe that inflation has had a significant impact on our revenues or operations.

ITEM 4.            CONTROLS AND PROCEDURES.

Evaluation of Disclosure Controls and Procedures

Disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (“Exchange Act”)) are designed to ensure that information required to be disclosed in reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms and that such information is accumulated and communicated to management, including the Chief Executive Officer and the Chief Financial Officer, to allow timely decisions regarding required disclosures.

In connection with the preparation of this report, our management, under the supervision and with the participation of the Chief Executive Officer and Chief Financial Officer, conducted an evaluation of the effectiveness of the design and operation of our disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures were effective.

Changes in Internal Control over Financial Reporting

There was no change in our internal control over financial reporting during the six months ended June 30, 2015, that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting. 

PART II: OTHER INFORMATION

ITEM 1.            LEGAL PROCEEDINGS

We are involved in, or have been involved in, arbitrations or various other legal proceedings that arise from the normal course of our business. We cannot predict the timing or outcome of these claims and other proceedings. The ultimate outcome of any litigation is uncertain, and either unfavorable or favorable outcomes could have a material negative impact on our results of operations, balance sheets and cash flows due to defense costs, and divert management resources.  Currently, we are not involved in any arbitration and/or other legal proceeding that we expect to have a material effect on our business, financial condition, results of operations and cash flows.

ITEM 1A.          RISK FACTORS.

Information regarding the Company’s risk factors appears in “Part I. – Item 1A. Risk Factors” of our Annual Report on Form 10-K for the fiscal year ended December 31, 2014, filed with the SEC on March 27, 2015. There have been no material changes from the risk factors previously disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2014.

ITEM 2.            UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS.

None.

ITEM 3.            DEFAULTS UPON SENIOR SECURITIES.

None.

ITEM 4.            MINE SAFETY DISCLOSURES

Not Applicable.

ITEM 5.            OTHER INFORMATION.

None.

ITEM 6.            EXHIBITS

SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

August 14, 2015