TANDEM DIABETES CARE 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

For the Transition Period from              to                 

Commission File Number 001-36189

Tandem Diabetes Care, Inc.

(Exact name of registrant as specified in its charter)

(858) 366-6900

Registrant’s telephone number, including area code

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

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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See 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).    Yes  ☐    No   ☒

As of October 28, 2016, there were 30,642,276 shares of the registrant’s Common Stock outstanding.

TABLE OF CONTENTS

PART I. FINANCIAL INFORMATION

TANDEM DIABETES CARE, INC.

CONDENSED BALANCE SHEETS

(In thousands, except par value)

See accompanying notes to unaudited condensed financial statements.

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TANDEM DIABETES CARE, INC.

CONDENSED STATEMENTS OF OPERATIONS and comprehensive loss

(Unaudited)

(In thousands, except per share data)

See accompanying notes to unaudited condensed financial statements.

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TANDEM DIABETES CARE, INC.

CONDENSED STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

See accompanying notes to unaudited condensed financial statements.

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TANDEM DIABETES CARE, INC.

NOTES TO UNAUDITED CONDENSED FINANCIAL STATEMENTS

1. Organization and Basis of Presentation

The Company

Tandem Diabetes Care, Inc. is a medical device company focused on the design, development and commercialization of a family of products for people with insulin-dependent diabetes. The Company is incorporated in the state of Delaware. Unless the context requires otherwise, the terms the “Company” or “Tandem” refer to Tandem Diabetes Care, Inc.

The Company manufactures and sells insulin pump products in the United States that are designed to address large and differentiated needs of the insulin-dependent diabetes market. During the first three quarters of 2016, the Company’s pump products included:

 The Company designed and commercialized its products based on its proprietary technology platform and consumer-focused approach. The Company began commercial sales of its first product, t:slim, in August 2012. During 2015, the Company commenced commercial sales of two additional insulin pumps: the t:flex Pump in May 2015 and t:slim G4 Pump in September 2015.

In July 2016, the Company received clearance from the U.S. Food and Drug Administration (“FDA”) to begin offering the Tandem Device Updater, which is a Mac^® and PC-compatible tool for the remote update of Tandem insulin pump software.

In October 2016, the Company began shipping the t:slim X2^TM Insulin Pump, a next generation t:slim Pump. As a result, the Company discontinued new shipments of the t:slim Pump, though the Company will continue to provide ongoing service and support to existing t:slim Pump customers.

Basis of Presentation

The Company has prepared the accompanying unaudited condensed financial statements in accordance with accounting principles generally accepted in the United States of America (“U.S. GAAP”) for interim financial information and pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments which are of a normal and recurring nature, considered necessary for a fair presentation of the financial information contained herein, have been included.

Interim financial results are not necessarily indicative of results anticipated for the full year or any other period(s). These unaudited condensed financial statements should be read in conjunction with the Company’s audited financial statements and footnotes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015, from which the balance sheet information herein was derived but excludes disclosures required by U.S. GAAP for complete financial statements.

2. Summary of Significant Accounting Policies

There have been no significant changes in our significant accounting policies during the nine months ended September 30, 2016, as compared with those disclosed in our Annual Report on Form 10-K for the year ended December 31, 2015, except for the accounting policies related to trade-in rights, which are included herein.

Use of Estimates

The preparation of the financial statements in conformity with U.S. GAAP requires management to make informed estimates and assumptions that affect the reported amounts of assets, liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities in the Company’s financial statements and accompanying notes as of the date of the financial statements. Actual results could materially differ from those estimates and assumptions.

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Restricted Cash

Restricted cash as of September 30, 2016 and December 31, 2015 was comprised of a $2.0 million minimum cash balance requirement in connection with the Company’s Term Loan Agreement, as amended by Consent and Amendment Agreement, dated June 20, 2014, Omnibus Amendment Agreement No. 2, dated February 23, 2015 and Amendment No. 3 to Term Loan Agreement, dated January 8, 2016 with Capital Royalty Partners II, L.P. and its affiliate funds (“Capital Royalty Partners”) (as amended, the “Term Loan Agreement”) (see Note 6, “Term Loan Agreement”).

Accounts Receivable

The Company grants credit to various customers in the normal course of business. The Company maintains an allowance for doubtful accounts for potential credit losses. Provisions are made, generally, for receivables greater than 120 days past due and based upon a specific review of other outstanding invoices. Uncollectible accounts are written off against the allowance after appropriate collection efforts have been exhausted and when it is deemed that a balance is uncollectible.

Fair Value of Financial Instruments

The carrying amounts of cash and cash equivalents, accounts receivable, accounts payable, accrued expense, and employee-related liabilities are reasonable estimates of their fair values because of the short-term nature of these assets and liabilities. Short-term investments and foreign exchange forward contracts that are not designated as hedges are carried at fair value. Based on the borrowing rates currently available for loans with similar terms, the Company believes that the fair value of its long-term notes payable approximates its carrying value.

Revenue Recognition

Revenue is generated from sales, in the United States, of insulin pumps, disposable cartridges and infusion sets to individual customers and third-party distributors that resell the product to insulin-dependent diabetes customers. The Company is paid directly by customers who use the products, distributors and third-party insurance payors.

Revenue is recognized when persuasive evidence of an arrangement exists, delivery has occurred and title passed, the price is fixed or determinable, and collectability is reasonably assured. These criteria are applied as follows:

Trade-In Rights

In July 2016, the Company announced and launched a Technology Upgrade Program that provides eligible t:slim and t:slim G4 Pump customers a path forward to the t:slim X2 Pump. The t:slim X2 Pump is the next generation t:slim Pump that is updateable with PMA classified software, such as CGM integration, using the Tandem Device Updater. Participating customers have the right to trade in the original t:slim Pump and t:slim G4 Pump for a new t:slim X2 Pump when available, under a variable pricing structure. The Technology Upgrade Program expires on September 30, 2017.

The trade-in rights are accounted for as guarantees or rights to return based on specific factors and circumstances, including the period of time the trade-in rights are exercisable, the likelihood that the trade-in rights will be exercised, and the amount of the specified-price trade-in value.

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The Company has determined that trade-in rights for t:slim G4 Pump customers are guarantees. The Company accounts for the guarantees under applicable accounting standards, which requires a guarantor to recognize, at the inception of a guarantee, a liability for the estimated fair value of the obligation undertaken in issuing certain guarantees. Subsequently, the initial liability recognized for the guarantee is generally reduced as the Company is released from the risk under the guarantee, which is when the trade-in right is exercised or the right expires. The guarantee is accounted for as an element of a multiple element arrangement. The estimated fair value of the guarantees are based on various economic and customer behavioral assumptions, including the probability of a trade-in, the specified trade-in amount, the expected fair value of the used t:slim G4 Pump at trade-in and the expected sales price of the t:slim X2 Pump. At September 30, 2016, $0.9 million was recorded as a guarantee liability in other current liabilities on the accompanying balance sheet.

The Company has determined that t:slim Pump trade-in rights are in-substance rights to return products. Such rights to return are accounted for pursuant to the right of return accounting guidance. As the Company does not have sufficient history to reasonably estimate returns associated with trade-in rights, all eligible t:slim Pump sales between July 1, 2016 and September 30, 2016 were recorded as deferred revenue until the trade-in right is exercised or the right expires. At September 30, 2016, $7.6 million was recorded as a trade-in rights reserve in deferred revenue on the accompanying balance sheet.

Revenue Recognition for Arrangements with Multiple Deliverables

The Company considers the deliverables in its product offering as separate units of accounting and recognizes deliverables as revenue upon delivery only if (i) the deliverable has standalone value and (ii) if the arrangement includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is probable and substantially controlled by the Company. The Company allocates consideration to the separate units of accounting, unless the undelivered elements were deemed perfunctory and inconsequential. The amount of the determined guarantee fair value is allocated in full to the guarantee and the remaining allocable consideration is allocated to other separate units of accounting using the relative selling price method, in which allocation of consideration is based on vendor-specific objective evidence (“VSOE”) if available, third-party evidence (“TPE”), or if VSOE and TPE are not available, management’s best estimate of a standalone selling price (“ESP”) for the undelivered elements.

The Company offers a cloud-based data management application, t:connect, which is made available to customers upon purchase of any of its insulin pumps. In July 2016, the Company received clearance from the FDA to begin offering the Tandem Device Updater, which is a Mac^® and PC-compatible tool for the remote update of Tandem insulin pump software. Utilizing Tandem Device Updater, the Company may from time to time provide future unspecified software upgrades to the insulin pump’s essential software. The t:connect service and the embedded right included with qualifying insulin pumps to receive on a when-and-if-available basis, future unspecified software upgrades relating to the product’s essential software are deemed undelivered elements at the time of the insulin pump sale. Because the Company has neither VSOE nor TPE for these deliverables, the allocation of revenue is based on the Company’s ESP. The Company establishes its ESP based on the estimated cost to provide such services, including consideration for a reasonable profit margin, which is then corroborated by comparable market data. The Company allocates fair value based on management’s ESP to these elements at the time of sale and is recognizing the revenue over a four-year period, which is the hosting period for t:connect and the period that software upgrades are expected to be provided. At September 30, 2016 and December 31, 2015, $1.3 million and $1.1 million, respectively, were recorded as deferred revenue for these undelivered elements. All other undelivered elements at the time of sale are deemed inconsequential or perfunctory.

Product Returns

The Company offers a 30-day right of return to its customers from the date of shipment of any of its insulin pumps, provided a physician’s confirmation of the medical reason for the return is received. Estimated allowances for sales returns are based on historical returned quantities as compared to pump shipments in those same periods of return. The return rate is then applied to the sales of the current period to establish a reserve at the end of the period. The return rates used in the reserve are adjusted for known or expected changes in the marketplace when appropriate. The allowance for product returns is recorded as a reduction of revenue and accounts receivable in the period in which the related sale is recorded. The amounts recorded on the Company’s balance sheet for product return allowance were $55,000 and $0.3 million at September 30, 2016 and December 31, 2015, respectively. Actual product returns have not differed materially from estimated amounts reserved in the accompanying condensed financial statements.

Warranty Reserve

The Company generally provides a four-year warranty on its insulin pumps to end user customers and may replace any pumps that do not function in accordance with the product specifications. Insulin pumps returned to the Company may be refurbished and redeployed. Additionally, the Company offers a six-month warranty on disposable cartridges and infusion sets. Estimated warranty costs are recorded at the time of shipment. Warranty costs are estimated based on the current expected replacement product cost and expected replacement rates based on historical experience. The Company evaluates the reserve quarterly and makes adjustments when appropriate. Changes to the actual replacement rates could have a material impact on the Company’s estimated liability.    

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At September 30, 2016 and December 31, 2015, the warranty reserve was $5.1 million and $3.5 million, respectively. The following table provides a reconciliation of the change in product warranty liabilities through September 30, 2016 (in thousands):

Stock-Based Compensation

Stock-based compensation cost is measured at the grant date based on the estimated fair value of the award, and the portion that is ultimately expected to vest is recognized as compensation expense over the requisite service period on a straight-line basis. The Company estimates the fair value of stock options issued under the 2013 Stock Incentive Plan (“2013 Plan”) and shares issued under the Employee Stock Purchase Plan (“ESPP”) using a Black-Scholes option-pricing model on the date of grant. The Black-Scholes option-pricing model requires the use of subjective assumptions including volatility, expected term, and risk-free rate. For awards that vest based on service conditions, the Company recognizes expense using the straight-line method less estimated forfeitures based on historical experience.

Net Loss Per Share

Basic net loss per share is calculated by dividing the net loss by the weighted average number of common shares that were outstanding for the period, without consideration for common stock equivalents. Diluted net loss per share is calculated by dividing the net loss by the sum of the weighted-average number of dilutive common share equivalents outstanding for the period determined using the treasury stock method. Dilutive common share equivalents are comprised of warrants, potential awards granted pursuant to the ESPP, and options outstanding under the Company’s other equity incentive plans. For all periods presented, there is no difference in the number of shares used to calculate basic and diluted shares outstanding due to the Company’s net loss position.

Potentially dilutive securities not included in the calculation of diluted net loss per share (because inclusion would be anti-dilutive) are as follows (in thousands, in common stock equivalent shares):

Reclassifications

Certain reclassifications of prior year amounts have been made to conform to the current year presentation.

Recent Accounting Pronouncements

In August 2016, the Financial Accounting Standards Board (“FASB”) issued new guidance that clarifies how entities should classify certain cash receipts and cash payments on the statement of cash flows. The guidance also clarifies how the predominance principle should be applied when cash receipts and cash payments have aspects of more than one class of cash flows. The guidance is effective for public business entities for fiscal years beginning after December 15, 2017, and interim periods within those years. The Company does not believe the adoption of the standard will have a material impact on the Company’s statement of cash flow.

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In June 2016, FASB issued a new credit loss standard that changes the impairment model for most financial assets and certain other instruments. The standard is effective for public business entities for annual periods beginning after December 15, 2019, and interim periods within those years. Early adoption is permitted for all entities for annual periods beginning after December 15, 2018, and interim periods within those years. The Company is in the process of assessing the impact of the adoption of the standard on its financial statements.

In March 2016, FASB issued an Accounting Standards Update on changing certain aspects of accounting for share-based payments to employees. The new guidance will require all income tax effects of awards to be recognized in the income statement when the awards vest or are settled. 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, and to make a policy election to account for forfeitures as they occur. The guidance is effective for public business entities for fiscal years beginning after December 15, 2016, and interim periods within those years. Early adoption is permitted, but all of the guidance must be adopted in the same period. The Company is in the process of assessing the impact of the adoption of the standard on its financial statements.

In February 2016, FASB issued final guidance for lease accounting. The new guidance requires lessees to put most leases on their balance sheet but to recognize expenses on their income statement in a manner similar to today’s accounting. The new guidance also eliminates today’s real estate-specific provisions for all entities. The standard is effective for public business entities for annual periods beginning after December 15, 2018, and interim periods within those years. Early adoption is permitted for all entities. The Company is in the process of assessing the impact of the adoption of the standard on its financial statements.

In April 2015, FASB issued new guidance, which amended requirements that require debt issuance costs, related to a recognized debt liability, to be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, effective for the Company beginning January 1, 2016 and applied retroactively for all consolidated balance sheets presented. The Company applied the amended presentation requirements in the first quarter 2016, which resulted in the reclassification of $0.4 million of debt issuance costs in the Company’s balance sheet from other long-term assets to long-term notes payable at December 31, 2015.

In May 2014, FASB and the International Accounting Standards Board issued a comprehensive new revenue recognition standard that will supersede existing revenue guidance under U.S. GAAP and International Financial Reporting Standards. The standard’s core principle is that a company will recognize revenue when it transfers promised goods or services to customers in an amount that reflects the consideration to which the company expects to be entitled in exchange for those goods or services. In doing so, companies will need to use more judgment and make more estimates than under current guidance. This may include identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation. On July 9, 2015, FASB approved a one-year deferral of the effective date of the standard to December 15, 2017 and early application is permitted, but not before the original effective date of December 15, 2016. The Company expects to adopt the new standard on January 1, 2018 and is in the process of assessing the impact of the adoption of the standard on its financial statements.

3. Short-Term Investments

The Company invests in various securities, principally in commercial paper issued by certain financial institutions and corporations. The following represents a summary of the estimated fair value of short-term investments at September 30, 2016 and December 31, 2015 (in thousands):

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4. Inventory

Inventory consisted of the following (in thousands):

Finished goods at September 30, 2016 included $1.8 million of deferred cost of sales associated with the trade-in rights related to the Technology Upgrade Program. The trade-in rights were accounted for pursuant to the right of return accounting guidance (see Note 2, “Summary of Significant Accounting Policies – Revenue Recognition”).

5. Fair Value Measurements

Authoritative guidance on fair value measurements defines fair value, establishes a consistent framework for measuring fair value, and expands disclosures for each major asset and liability category measured at fair value on either a recurring or a nonrecurring basis. Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or liability. As a basis for considering such assumptions, the authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

The following table presents information about the Company’s financial assets and liabilities measured at fair value on a recurring basis as of September 30, 2016 and December 31, 2015, and indicates the fair value hierarchy of the valuation techniques utilized by the Company to determine such fair value (in thousands):  

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The Company’s Level 2 financial instruments are valued using market prices on less active markets with observable valuation inputs such as interest rates and yield curves. The Company obtains the fair value of Level 2 financial instruments from quoted market prices, calculated prices or quotes from third-party pricing services. The Company validates these prices through independent valuation testing and review of portfolio valuations provided by the Company’s investment managers. There were no transfers between Level 1 and Level 2 securities during the nine months ended September 30, 2016.

For the three months ended September 30, 2016, the Company recorded a $0.9 million guarantee liability in other current liabilities on the accompanying balance sheet, as a reduction of revenue. Guarantees are classified within Level 3 of the fair value hierarchy. The estimated fair value of the guarantee is based on various economic and customer behavioral assumptions, including the probability that a trade-in right will be exercised, the specified trade-in amount, the expected fair value of the used t:slim G4 Pump at trade-in and the expected sales price of the t:slim X2 Pump (see Note 2, “Summary of Significant Accounting Policies – Revenue Recognition”). Changes in the probability of the trade-in have the most significant impact on the estimate of the fair value of the liability.

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6. Term Loan Agreement

In January 2016, the Company entered into Amendment No. 3 to Term Loan Agreement with Capital Royalty Partners (“Third Amendment”), which was previously amended by Consent and Amendment Agreement, dated June 20, 2014, and Omnibus Amendment Agreement No. 2, dated February 23, 2015.

Under the Term Loan Agreement, the Company had aggregate borrowings outstanding of $30.2 million (such amount, the “First Tranche”) as of December 31, 2015. Under the Third Amendment, the Company borrowed $15.0 million (such amount, the “Second Tranche”) in January 2016, and the Third Amendment provides the Company with a one-time option to draw up to an additional $35.0 million in increments of $5.0 million on or before December 31, 2016 (such amount, to the extent drawn, the “Third Tranche”).

The other principal terms of the Term Loan Agreement were not amended by the Third Amendment. Accordingly, interest continues to be payable, at the Company’s option, (i) in cash at a rate of 11.5% per annum or (ii) at a rate of 9.5% of the 11.5% per annum in cash and 2.0% of the 11.5% per annum (the “PIK Loan”) to be added to the principal of the loan and subject to accruing interest. Interest-only payments continue to be due quarterly on March 31, June 30, September 30 and December 31 of each year of the interest-only payment period, which ends on December 31, 2019. The principal balance continues to be due in full at the end of the term of the loan, which is March 31, 2020 (the “Maturity Date”). The Term Loan Agreement provides for prepayment fees in an amount equal to one percent (1.0%) of the outstanding balance of the loan if the loan is repaid prior to March 31, 2017, after which there is no prepayment fee. The term loan is collateralized by all assets of the Company. The principal financial covenants continue to require that the Company attain minimum annual revenues of $65.0 million in 2016, $80.0 million in 2017 and $95.0 million each year thereafter until the Maturity Date. At September 30, 2016, the Company was in compliance with all of the covenants in the Term Loan Agreement.

The Company had elected to pay interest in cash at a rate of 11.5% per annum through September 30, 2015. Beginning October 1, 2015, the Company elected to pay interest in cash at a rate of 9.5% per annum and to have 2.0% per annum added to the principal of the loan. As a result, $675,000 and $153,000 was added to the principal of the loan for the nine months ended September 30, 2016 and the three months ended December 31, 2015, respectively. The Company had $45.8 million of aggregate borrowings outstanding under the Term Loan Agreement as of September 30, 2016.

Pursuant to the Third Amendment, the Company has agreed to pay, on the earlier of (i) the Maturity Date; (ii) the date that the loan under the Term Loan Agreement becomes due, and (iii) the date on which the Company makes a voluntary pre-payment of the loan, a financing fee equal to three percent (3.0%) of the sum of (x) the aggregate amount of the Second Tranche and Third Tranche drawn, and (y) any PIK Loans issued in relation to the Second Tranche and Third Tranche (collectively, the “Back End Financing Fee”). As of September 30, 2016 the Company had accrued $0.5 million for the Back End Financing Fee in other long-term liabilities and as contra-debt in notes payable-long-term on the accompanying balance sheet.

The Company treated this amendment as a modification. The present value of the future cash flows under the Third Amendment did not exceed the present value of the future cash flows under the previous terms by more than 10%. The Back End Financing Fee and the remaining balance of debt issuance costs and debt discount of the loan are amortized to interest expense over the remaining term of the Third Amendment using the effective interest method.

7. Stockholders’ Equity

Public Offering

In the first quarter of 2015, the Company completed a public offering of 6,037,500 shares of its common stock at a public offering price of $11.50 per share. Net cash proceeds from the public offering were approximately $64.9 million, after deducting underwriting discounts, commissions and offering expenses paid by the Company.

Shares Reserved for Future Issuance

The following shares of the Company’s common stock were reserved for future issuance at September 30, 2016:

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The Company issued 137,341 shares of its common stock upon the exercise of stock options and warrants during the nine months ended September 30, 2016, and issued 260,091 shares of its common stock upon the exercise of stock options and warrants during the year ended December 31, 2015.

The ESPP enables eligible employees to purchase shares of the Company’s common stock using their after tax payroll deductions, subject to certain conditions. The ESPP consists of a two-year offering period with four six-month purchase periods which begin in May and November of each year. There were 250,367 shares of the Company’s common stock purchased under the ESPP during the nine months ended September 30, 2016, and 302,171 shares of the Company’s common stock purchased under the ESPP during the year ended December 31, 2015.

Stock-Based Compensation

The assumptions used in the Black-Scholes option-pricing model are as follows:

The following table summarizes the allocation of stock-based compensation expense (in thousands):

The total stock-based compensation capitalized as part of the cost of inventory was $0.2 million and $0.1 million at September 30, 2016 and December 31, 2015, respectively.

8. Collaborations

DexCom Development and Commercialization Agreement

In February 2012, the Company entered into a Development and Commercialization Agreement (the “DexCom Agreement”) with DexCom, Inc. (“DexCom”) for the purpose of collaborating on the development and commercialization of an integrated system which incorporates the t:slim Insulin Delivery System with DexCom’s proprietary CGM system.

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Under the DexCom Agreement, the Company paid DexCom $1.0 million at the commencement of the collaboration in 2012, $1.0 million in 2014 upon the achievement of t:slim G4 Pump PMA submission to the FDA and an additional $1.0 million in September 2015 upon obtaining approval of the PMA submission from the FDA. All payments were recorded as research and development costs in their respective years.

Additionally, upon commercialization of the t:slim G4 Pump, and as compensation for the non-exclusive license rights, under the original DexCom Agreement the Company agreed to pay DexCom a royalty calculated at $100 per integrated system sold.

In September 2015, the Company entered into an amendment to the DexCom Agreement (the “Amendment”). Pursuant to the Amendment, in lieu of the $100 royalty payment for each integrated system sold, the Company agreed to commit $100 of each t:slim G4 integrated system sold to incremental marketing activities associated with t:slim G4 integrated systems that are in addition to a level of ordinary course marketing activities or marketing activities to support other Company and DexCom jointly funded development projects. The committed marketing fund is recorded as an increase to cost of sales and current liability in the period that the related t:slim G4 Pump sale is recorded. The Company has recorded such marketing fund activities of $0.1M and $0.6M for the three and nine months ended September 30, 2016, respectively. As of September 30, 2016 and December 31, 2015, the Company had a marketing fund liability of $0.9 million and $0.4 million, respectively, recorded in other current liabilities on the accompanying balance sheet.

JDRF Collaboration

In January 2013, the Company entered into a Research, Development and Commercialization Agreement (“JDRF Agreement”) with JDRF to develop the t:dual Infusion System, a first-of-its-kind, dual-chamber infusion pump for the management of diabetes. According to the terms of the JDRF Agreement, JDRF would provide research funding of up to $3.0 million based on the achievement of research and development milestones, not to exceed research costs incurred by the Company. 

In February 2016, the Company and JDRF entered into a termination agreement (“JDRF Termination Agreement”), where both parties mutually terminated the JDRF Agreement. As of December 31, 2015, milestone payment achievements totaled $0.7 million, and research and development costs were offset cumulatively by $0.5 million. Under the terms of the JDRF Termination Agreement, the Company agreed to repay JDRF $0.7 million, which is equal to the amount of milestone payments received by the Company to date. The Company accrued for the repayment in other current liabilities on the accompanying balance sheet as of December 31, 2015 and repaid such amount during the first quarter of 2016.

9. Commitments and Contingencies

From time to time, the Company may be subject to legal proceedings or regulatory encounters or other matters arising in the ordinary course of business, including actions with respect to intellectual property, employment, product liability, and contractual matters. In connection with these matters, the Company assesses, on a regular basis, the probability and range of possible loss based on the developments in these matters. A liability is recorded in the financial statements if it is believed to be probable that a loss has been incurred and the amount of the loss can be reasonably estimated. Because of the uncertainties related to the occurrence, amount, and range of loss on any pending actions, the Company is currently unable to predict their ultimate outcome, and, with respect to any pending litigation or claim where no liability has been accrued, to make a meaningful estimate of the reasonably possible loss or range of loss that could result from an unfavorable outcome. At each of September 30, 2016 and December 31, 2015, there were no material matters for which the negative outcome was considered probable or estimable.

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You should read the following discussion and analysis together with our financial statements and related notes in Part I, Item 1 of this Quarterly Report on Form 10-Q, or this Quarterly Report.

This Quarterly Report contains forward-looking statements within the meaning of the federal securities laws. These forward-looking statements are intended to qualify for the safe harbor from liability established by the Private Securities Litigation Reform Act of 1995. All statements included or incorporated by reference in this Quarterly Report, other than statements of historical fact, are forward-looking statements. You can identify forward-looking statements by the use of words such as “may,” “will,” “could,” “anticipate,” “expect,” “intend,” “believe,” “continue” or the negative of such terms, or other comparable terminology. Forward-looking statements also include the assumptions underlying or relating to such statements.

Our forward-looking statements are based on our management’s current assumptions and expectations about future events and trends, which affect or may affect our business, strategy, operations or financial performance. Although we believe that these forward-looking statements are based upon reasonable assumptions, they are subject to numerous known and unknown risks and uncertainties and are made in light of information currently available to us. Our actual results could differ materially from those anticipated in these forward-looking statements as a result of various factors, including those set forth below in the section entitled “Risk Factors” in Part II, Item 1A, and elsewhere in this Quarterly Report. You should read this Quarterly Report with the understanding that our actual future results may be materially different and worse from what we expect.

Moreover, we operate in an evolving environment. New risk factors and uncertainties emerge from time to time and it is not possible for our management to predict all risk factors and uncertainties, 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.

Forward-looking statements speak only as of the date they were made, and, except to the extent required by law or the rules of the NASDAQ Stock Market, we undertake no obligation to update or review any forward-looking statement because of new information, future events or other factors.

We qualify all of our forward-looking statements by these cautionary statements.

Overview

We are a medical device company with an innovative approach to the design, development and commercialization of a family of products for people with insulin-dependent diabetes. Our advantage is rooted in our unique consumer-focused approach and proprietary technology platform. This allows us to deliver innovative hardware and software solutions to meet the various needs and preferences of people with diabetes and their healthcare providers. We manufacture and sell insulin pump products in the United States that are designed to address large and differentiated segments of the insulin-dependent diabetes market. During the first three quarters of 2016, our pump products included:

Our innovative approach to product design and development is consumer-focused and based on our extensive market research as we believe the user is the primary decision maker when purchasing an insulin pump. This research consists of interviews, focus groups and online surveys to understand what people with diabetes, their caregivers and healthcare providers are seeking in order to improve diabetes therapy management. We also apply the science of human factors to our design and development process, which seeks to optimize our devices, allowing users to successfully operate our devices in their intended environment.

We developed our products to provide the specific features that people with insulin-dependent diabetes seek in a next-generation insulin pump. Our proprietary pumping technology allows us to design the slimmest and smallest durable insulin pumps on the market, without sacrificing insulin capacity. Our technology platform features our patented Micro-Delivery technology, a miniaturized pumping mechanism which draws insulin from a flexible bag within the pump’s cartridge, rather than relying on a syringe and plunger mechanism. It also features an easy-to-navigate software architecture, a vivid color touchscreen and a micro-USB connection that supports both a rechargeable battery and t:connect, our custom cloud-based data management application that provides a fast, easy and visual way to display therapy management data from the pump and supported blood glucose meters.

We began commercial sales of our original t:slim Pump in August 2012. During 2015, we commenced commercial sales of two additional insulin pumps: the t:flex Pump in May 2015 and t:slim G4 Pump in September 2015.

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Product Development

In July 2016, we received clearance from the U.S. Food and Drug Administration, or FDA, to begin offering the Tandem Device Updater, which is a Mac^® and PC-compatible tool for the remote update of Tandem insulin pump software, designed to update software and add new features for our pumps from a personal computer. This tool allows us to provide our customers access to new and enhanced features faster than the industry has been able to in the past, and separate from the typical multi-year pump reimbursement cycle.

In the third quarter of 2016, we began to roll out the Tandem Device Updater to our customer base. The first use of the Tandem Device Updater is for the deployment of the latest t:slim Insulin Pump software to in-warranty t:slim Pumps purchased before April 2015. Future software improvements and enhancements will be implemented through the Tandem Device Updater as they are cleared for commercial distribution by the FDA.

In October 2016, we began shipping the t:slim X2 Pump, a next generation t:slim Pump. The t:slim X2 Pump was specifically designed to be updateable with PMA-classified software, such as CGM integration, using the Tandem Device Updater. However, software updates and new features are not currently available for the t:slim X2 Pump. As a result of the commercialization of the t:slim X2 Pump, in October 2016 we discontinued new shipments of our t:slim Pump, though we will continue to provide ongoing service and support to our existing t:slim Pump customers.

We have a number of additional products and product enhancements that we plan to launch over the next several years, pending appropriate regulatory clearances.

Commercialization and Technology Upgrade Program

Since inception, we have derived nearly all of our sales from the shipment of insulin pumps and associated supplies in the United States. We consider the number of units shipped per quarter to be an important metric for managing our business. We have shipped more than 46,000 insulin pumps since the initiation of our commercial efforts in 2012. Pump shipments are broken down by product and by quarter as follows:

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In July 2016, we launched a Technology Upgrade Program that provides eligible t:slim and t:slim G4 Pump customers a path towards ownership of the t:slim X2 Pump by providing customers the right to trade in a t:slim Pump or t:slim G4 Pump for a new t:slim X2 Pump when available, under a variable pricing structure. The Technology Upgrade Program expires on September 30, 2017.

Due to the high degree of accounting complexity, the Technology Upgrade Program has created, and will continue to create, unpredictable financial results for the duration of the program. The accounting treatment for this program requires the deferral of some portion (up to 100%) of sales and cost of sales for shipments of eligible pumps beginning in the third quarter of 2016. We have determined that, from an accounting perspective, the opportunity for a customer to trade in a t:slim or t:slim G4 Pump represents either a right of return or a guarantee at the time of the initial product purchase. Because we have not offered an upgrade program in the past, we do not have sufficient history with similar upgrade programs to estimate the number of customers that will participate. As a result, sales and cost of sales for all eligible t:slim Pump and t:slim G4 Pump shipments are subject to deferral. The amount of sales and cost of sales deferred varies based on a number of factors, including the model of pump involved and the timing of the initial sales relative to the availability of certain future products. We expect to recognize the deferred amount of sales and cost of sales at the earlier of when the Company’s obligations under the Technology Upgrade Program are satisfied or when the Technology Upgrade Program expires. If a customer elects to participate in the Technology Upgrade Program, we will recognize upgrade fees that we receive, if any, and the associated costs at the time of fulfilling the given obligation. At this time we are not able to estimate when we will recognize deferred sales or costs of goods sold as a result of the Technology Upgrade Program, nor are we able to estimate the amount of upgrade fees or associated costs for a customer’s election to participate in the Technology Upgrade Program.

For the three months ended September 30, 2016 and 2015, our sales were $12.3 million and $15.7 million, respectively. For the three months ended September 30, 2016, we recorded net deferrals of $8.4 million in sales and $1.4 million in cost of sales, respectively, as a result of the Technology Upgrade Program. For the three months ended September 30, 2016 and 2015, our net loss was $29.8 million and $19.6 million, respectively. For the nine months ended September 30, 2016 and 2015, our sales were $55.3 million and $43.7 million, respectively. For the nine months ended September 30, 2016 and 2015, our net loss was $68.6 million and $60.3 million, respectively.

Overall, we have experienced considerable sales growth since the commercial launch of t:slim in the third quarter of 2012, while incurring operating losses since our inception. Our operating results fluctuate on a quarterly or annual basis, particularly in the periods surrounding anticipated and actual regulatory approvals and initial stages of commercialization of our new products and those of our competitors. These fluctuations have been, and may continue to be, more pronounced following the commencement of the Technology Upgrade Program.

We believe that the timing of the commercial launch of the t:slim X2 Pump has negatively impacted our aggregate pump shipments during the three months ended September 30, 2016 and may cause further fluctuations in quarterly pump shipments throughout the duration of the Technology Upgrade Program. In particular, in the period leading up to the commercial launch of the t:slim X2 Pump, we believe there was an increasing number of potential customers who delayed their purchasing decision until they could include the t:slim X2 Pump in their decision-making process. In addition, recent regulatory filings, approvals and new product launches by our competitors have and may continue to negatively impact the purchasing decisions of potential customers.

A substantial portion of the purchase price of an insulin pump is typically paid for by third-party payors, including private insurance companies, preferred provider organizations and other managed care providers. Access to adequate coverage and reimbursement for our current and future products by third-party payors is essential to the acceptance of our products by customers. Future sales of our current and future products will be limited unless our customers can rely on third-party payors to pay for all or part of the associated purchase cost. For example, effective July 1, 2016, UnitedHealthcare designated one of our competitors as their preferred, in-network durable medical equipment provider of insulin pumps for most customers over the age of 18. We expect this decision will prevent a majority of UnitedHealthcare members from purchasing an insulin pump from us for the foreseeable future. However, in most other circumstances in which we do not have contracts established with third-party payors, we utilize our network of national and regional distributors to service our customers.

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We believe we can ultimately achieve profitability because our proprietary technology platform will allow us to maximize efficiencies in the development, production and sale of our products. By offering a family of products, all of which are based on our proprietary technology platform, we believe we can develop and bring to market products more rapidly, while significantly reducing our design and development costs. Due to shared product design features, our production system is adaptable to new products and we intend to leverage our shared manufacturing infrastructure to reduce our product costs and drive operational efficiencies. Further, we expect to continue to increase production volume and to reduce the per-unit production overhead cost for our pump products and their associated disposable cartridges over time. By expanding our product offerings to address people in different segments of the large and growing insulin-dependent diabetes market, we believe we can increase the productivity of our sales, clinical and marketing organization, and utilize the expertise of our customer, technical and support services, thereby improving our operating margin.

From inception through September 30, 2016, we have primarily financed our operations through sales of equity securities, and, to a lesser extent, debt financings. We expect to continue to incur net losses for the next several years, and may require additional capital through equity and debt financings in order to fund our operations until we achieve a level of revenue adequate to support our cost structure.

In the first quarter of 2016, we entered into a third amendment (the “Third Amendment”) to our Term Loan Agreement, as amended by Consent and Amendment Agreement, dated June 20, 2014, Omnibus Amendment Agreement No. 2, dated February 23, 2015 and Amendment No. 3 to Term Loan Agreement, dated January 8, 2016 (as amended, the “Term Loan Agreement”) with Capital Royalty Partners II, L.P. and its affiliate funds (“Capital Royalty Partners”). The Third Amendment granted us the right to borrow up to an additional $50.0 million. We borrowed $15.0 million of this amount in January 2016, and the Third Amendment provides us with a one-time option to draw up to an additional $35.0 million in increments of $5.0 million on or before December 31, 2016.

We may not be able to achieve profitability in the future. For additional information about the risks and uncertainties associated with our business, see the section entitled “Risk Factors” in Part II, Item 1A of this Quarterly Report.

Components of Results of Operations

Sales

We offer a family of products for people with insulin-dependent diabetes. We commenced commercial sales of the t:slim Pump in the United States in the third quarter of 2012. We launched our second insulin pump product, t:flex, in the second quarter of 2015, and launched our third insulin pump product, t:slim G4, in September 2015. In October of 2016, we began shipping the t:slim X2 Pump. Our products include these insulin pumps, as well as disposable cartridges and infusion sets. We also offer accessories including protective cases, belt clips, and power adapters. Sales of accessories since commercial launch have not been significant.

We primarily sell our products through national and regional distributors on a non-exclusive basis. These distributors are generally providers of medical equipment and supplies to individuals with diabetes. Our primary end customers are people with insulin-dependent diabetes. Similar to other durable medical equipment, the primary payor is generally a third-party insurance carrier and the customer is usually responsible for any medical insurance plan copay or coinsurance requirements. We believe our recent expansion of our sales, clinical and marketing infrastructure will allow us to engage with more potential customers, their caregivers and healthcare providers on a more frequent basis to promote our products.

Our sales may fluctuate on a quarterly basis in the future due to a variety of factors, including the impact of:

In general, as a result of these and other factors, we have experienced, and expect to continue to experience, product shipments being weighted heavily towards the second half of the year, with the highest percentage of product shipments in the fourth quarter of the year. Consistent with prior results, we also expect product shipments from the fourth quarter to the following first quarter to decrease.

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In particular, our quarterly sales have fluctuated, and may continue to fluctuate, substantially in the periods surrounding anticipated and actual regulatory approvals and commercial launches of new products by us or our competitors. For instance, customers may defer a purchasing decision if they believe that a new product may be launched in the future. Additionally, upon the announcement of the FDA approval or commercial launch of a new product, whether our own or of one of our competitors, potential new customers may reconsider their purchasing decision or take additional time to consider the new approval or product in their purchasing decision. For example, in 2015, we believe that the timing of the regulatory approval and commercial launch of t:slim G4 contributed to our product shipments being weighted even more heavily towards the fourth quarter of the year. Similarly, in 2016, we believe that our pump shipments were negatively impacted during the three-month period ended September 30, 2016, as we announced the launches of the t:slim X2 Pump and the Technology Upgrade Program during that quarter, and one of our competitors announced the future availability of two new products. However, we are not able to quantify the extent of the impact of these events on our potential customers’ purchasing decisions.

Cost of Sales

We manufacture our pumps and disposable cartridges at our manufacturing facility in San Diego, California. Infusion sets and pump accessories are manufactured by third-party suppliers. Cost of sales includes raw materials, labor costs, manufacturing overhead expenses, product training costs, reserves for expected warranty costs, and scrap and inventory obsolescence. Manufacturing overhead expenses are currently a significant portion of our per-unit costs but continue to decline as our production volumes grow. These manufacturing overhead expenses include expenses relating to quality assurance, manufacturing engineering, material procurement, inventory control, facilities, equipment, information technology and operations supervision and management. We anticipate that our cost of sales will continue to increase as our products continue to gain broader market acceptance and our product sales increase.

We expect our overall gross margin percentage, which for any given period is calculated as sales less cost of sales divided by sales, to improve over the long term, as our sales increase and we have more opportunities to spread our overhead costs over larger production volumes. We expect that we will be able to leverage our manufacturing cost structure among our pump products that utilize the same core infrastructure. However, we do expect our overall gross margin to fluctuate in future quarterly periods as a result of numerous factors besides those associated with production volumes, such as the Technology Upgrade Program and its related financial and accounting impact, the changing mix of products sold with different gross margins, the changing percentage of products sold to distributors versus directly to individual customers, varying levels of reimbursement among third-party payors, the timing and success of new regulatory approvals and product launches, warranty and training costs, and changes in our manufacturing processes, costs or output, changes in our manufacturing capacity or output as well as the impact of implementing additional automated manufacturing equipment and expanding our manufacturing facilities as we attempt to manufacture our products on a larger scale.

Selling, General and Administrative

Our selling, general and administrative, or SG&A, expenses primarily consist of salary, cash-based incentive compensation, fringe benefits and non-cash stock-based compensation for our executive, financial, marketing, sales, business development, regulatory affairs and administrative functions. Other significant SG&A expenses include those incurred for product demonstration samples, commercialization activities associated with new product launches, travel, trade shows, outside legal fees, independent auditor fees, outside consultant fees, insurance premiums, facilities costs and information technology costs. We expect our SG&A expenses to increase as our business expands, including the potential future expansion of the number of sales territories in which we operate.

Research and Development

Our research and development, or R&D, activities primarily consist of engineering and research programs associated with our products under development, as well as R&D activities associated with our core technologies and processes. R&D expenses are primarily related to employee compensation, including salary, fringe benefits, non-cash stock-based compensation and temporary employee expenses. We also incur R&D expenses for supplies, development prototypes, outside design and testing services, depreciation, allocated facilities and information services, payments under our licensing, development and commercialization agreements and other indirect costs. We expect our R&D expenses, including clinical trial costs, to increase as we initiate and advance our development projects.

Other Income and Expense

Our other income and expense primarily consists of interest expense and amortization of debt discount and issuance costs associated with the Term Loan Agreement. At September 30, 2016, there was $45.8 million of outstanding principal under the Term Loan Agreement, which accrues interest at a rate of 11.5% per annum. We expect interest expense to increase in 2016 as a result of additional borrowings under the Term Loan Agreement as compared to 2015 (see the section below entitled “Indebtedness”).

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Results of Operations

Comparison of the Three Months Ended September 30, 2016 and 2015

Sales. Sales for the three months ended September 30, 2016 were $12.3 million, representing a decrease of 22% compared to sales of $15.7 million for the same period in 2015.

For the three months ended September 30, 2016 we deferred $8.4 million of pump sales as the result of our Technology Upgrade Program. Sales of insulin pumps were $6.9 million and $12.8 million, respectively, for the three months ended September 30, 2016 and 2015. Sales of pump-related supplies primarily accounted for the remainder of our sales during those periods. Sales of accessories were not significant in either of the reported periods.

The net decrease in sales during the three months ended September 30, 2016 compared to the same period in 2015 was primarily attributable to our deferral of sales of eligible insulin pumps due to the Technology Upgrade Program. Notwithstanding the decrease in our reported sales during this period, we had a 14% increase in aggregate pump shipments from 3,431 in the third quarter of 2015 to 3,896 in the third quarter of 2016. We also experienced an increase in sales of pump-related supplies from our growing installed base.  

Our percentage of sales to distributors versus individual customers is principally determined by the mix of customers ordering our products within the period and whether or not we have a contractual arrangement with their underlying third-party insurance payor. Sales to distributors accounted for 67% and 77% of our total sales for the three months ended September 30, 2016 and 2015, respectively. The percentage of sales to distributors during the three months ended September 30, 2016 decreased five percentage points as a result of sales deferred due to the Technology Upgrade Program and the expected launch of the t:slim X2 Pump. In addition, the percentage decreased due to UnitedHealthcare’s decision to designate one of our competitors as their preferred, in-network durable medical equipment provider of insulin pumps for most customers over the age of 18, effective July 1, 2016. Previously, UnitedHealthcare’s members accessed our products through one of our distributors.

Cost of Sales and Gross Profit (Loss). Our cost of sales for the three months ended September 30, 2016 was $13.9 million, representing an increase of 36% compared to $10.2 million for the same period in 2015. Gross loss for the three months ended September 30, 2016 was $1.6 million and gross margin was (13)%, compared to gross profit of $5.5 million and gross margin of 35% for the same period in 2015.

 The decrease in our gross profit (loss) for the three months ended September 30, 2016 from the comparable period in 2015 was primarily due to the net $7.0 million reduction in gross profit associated with the Technology Upgrade Program. During the period, we recorded net deferrals of $8.4 million in sales and $1.4 million in cost of sales. In addition, we recorded a $1.1 million charge for inventory obsolescence as the result of the commercialization of the t:slim X2 Pump, the launch of the Technology Upgrade Program and the associated decrease in overall demand for our t:slim G4 Pump. This charge negatively impacted our gross margin during the three months ended September 30, 2016 by nine percentage points.

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Our manufacturing overhead costs are a significant component of the costs of our products. Our gross margin was positively impacted by a substantial decrease in per-unit manufacturing overhead costs, which was driven by increased production volumes and manufacturing efficiencies. This improvement was offset by an increase in our non-manufacturing costs as a percentage of sales, which primarily consists of warranty, freight, training, and royalty costs. The gross margin was also impacted by an increase in sales of pump-related supplies, which generally have lower gross margins than our insulin pumps.

During the period of the Technology Upgrade program, we expect the pump gross margin will fluctuate significantly. Following the expiration of the Technology Upgrade Program, we expect our gross margin on insulin pumps to be higher than our gross margin on pump-related supplies, which is consistent with our historical experience. We will continue to increase our manufacturing operations and costs as we address increasing production volume requirements. Therefore, our manufacturing overhead costs will continue to be a significant component of the costs of our products. As a result our manufacturing overhead costs will continue to impact our gross margins as we attempt to manufacture our products on a larger scale, launch new products, change our manufacturing processes, change our manufacturing capacity or output, implement additional automated manufacturing equipment and expand our manufacturing facilities.

Selling, General and Administrative Expenses. SG&A expenses increased 8% to $20.7 million for the three months ended September 30, 2016 from $19.1 million for the same period in 2015. The increase in SG&A expenses was primarily the result of the expansion of our commercial operations during 2016. We expanded the number of our sales territories from 60 to 72 in early 2016, as well as increased our customer and technical support personnel throughout the year to service our growing customer base. Territories are maintained by sales representatives and field clinical specialists, and supported by managed care liaisons, additional sales management and other customer support personnel. Employee-related expenses for our sales, general and administrative functions comprise the majority of the SG&A expenses. Employee-related expenses in the third quarter of 2016 increased $1.9 million, offset by a decrease of $0.3 million in outside services and supplies.

Research and Development Expenses. R&D expenses increased 21% to $6.2 million for the three months ended September 30, 2016 from $5.1 million for the same period in 2015. The increase in R&D expenses was primarily the result of an increase of $1.7 million in clinical trial expenses, licensing fees, supplies and outside services, as well as an increase in employee-related expenses of $0.4 million. The increase was offset by a $1.0 million milestone payment made to DexCom, under the DexCom Agreement, in the three months ended September 30, 2015.

Other Income and Expense. Other expense for the three months ended September 30, 2016 and 2015 was $1.4 million and $0.9 million, respectively. Other expense for both periods was primarily comprised of interest expense associated with the Term Loan Agreement. The increase in expense was due to $15.0 million of additional borrowing under the Third Amendment in 2016. Interest currently accrues at a rate of 11.5% per annum. The outstanding principal balances under the Term Loan Agreement was $45.8 million and $30.0 million as of September 30, 2016 and September 30, 2015, respectively. Other income for both periods presented was not significant.

Comparison of the Nine Months Ended September 30, 2016 and 2015

Sales. Sales for the nine months ended September 30, 2016 were $55.3 million, representing an increase of 27% compared to sales of $43.7 million for the same period in 2015.

For the nine months ended September 30, 2016, we deferred $8.4 million of pump sales as the result of our Technology Upgrade Program. Sales of insulin pumps were $41.2 million and $35.8 million, respectively, for the nine months ended September 30, 2016 and 2015. Sales of pump-related supplies primarily accounted for the remainder of our sales during those periods. Sales of accessories were not significant in either of the reported periods.

The increase in sales during the nine months ended September 30, 2016 compared to the same period in 2015 was primarily attributable to a 35% increase in pump shipments from 9,249 in the first nine months of 2015 to 12,520 in the first nine months of 2016. During the first nine months of 2016, we expanded from 60 to 72 sales territories. We also experienced an increase in sales of pump-related supplies from our growing installed base. The increase in sales was offset by the deferral of sales of eligible insulin pumps due to the Technology Upgrade Program.

Our percentage of sales to distributors versus direct customers is principally determined by the mix of customers ordering our products within the period and whether or not we have a contractual arrangement with their underlying third-party insurance payor. Sales to distributors accounted for 74% and 77% of our total sales for the nine months ended September 30, 2016 and 2015, respectively. The percentage decrease was primarily due to UnitedHealthcare’s decision to designate one of our competitors as their preferred, in-network durable medical equipment provider of insulin pumps for most customers over the age of 18, effective July 1, 2016. In addition, the percentage decrease was partially the result of the deferrals associated with the Technology Upgrade Program and launch of the t:slim X2 Pump.

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Cost of Sales and Gross Profit. Our cost of sales for the nine months ended September 30, 2016 was $41.8 million, representing an increase of 37% compared to $30.6 million for the same period in 2015. Gross profit for the nine months ended September 30, 2016 was $13.5 million and gross margin was 24%, compared to gross profit of $13.1 million and gross margin of 30% for the same period in 2015.

Our gross profit for the nine months ended September 30, 2016 was negatively impacted by the net $7.0 million reduction in gross profit associated with the Technology Upgrade Program. During the period, we recorded net deferrals of $8.4 million in sales and $1.4 million in cost of sales. In addition, we recorded a $1.1 million charge for inventory obsolescence as the result of the commercialization of the t:slim X2 Pump, the launch of the Technology Upgrade Program and the associated decrease in overall demand for our t:slim G4 Pump. This charge negatively impacted our gross margin during the nine months ended September 30, 2016 by two percentage points.

Our manufacturing overhead costs are a significant component of the costs of our products. Our gross margin was positively impacted by a substantial decrease in per-unit manufacturing overhead costs, which was driven by increased production volumes and manufacturing efficiencies. The gross margin was also impacted by an increase in sales of pump-related supplies, which generally have lower gross margins than our insulin pumps.

Selling, General and Administrative Expenses. SG&A expenses increased 10% to $63.8 million for the nine months ended September 30, 2016 from $58.1 million for the same period in 2015. The increase in SG&A expenses was primarily the result of the expansion of our commercial operations during the first quarter of 2016. Employee-related expenses for our sales, general and administrative functions comprise the majority of the SG&A expenses. Such employee-related expenses increased $5.1 million in the nine months ended September 30, 2016 as compared to the same period in 2015, including an increase of $6.1 million in salaries, cash-based incentive compensation and fringe benefits, offset by a decrease in non-cash stock-based compensation of $1.0 million. SG&A expenses also increased $0.6 million associated with outside services, marketing and promotional activities, tradeshows and travel expenses.

Research and Development Expenses. R&D expenses increased 13% to $14.5 million for the nine months ended September 30, 2016 from $12.8 million for the same period in 2015. The increase in R&D expenses was primarily the result of an increase of $1.8 million in clinical trial expenses, licensing fees, supplies and outside services, as well as an increase in employee-related expenses of $0.9 million. The increase was offset by a $1.0 million milestone payment made to DexCom under the DexCom Agreement in the nine months ended September 30, 2015.

Other Income and Expense. Other expense for the nine months ended September 30, 2016 and 2015 was $3.9 million and $2.5 million, respectively. Other expense for both periods was primarily comprised of interest expense associated with the Term Loan Agreement. The increase in expense was due to $15.0 million of additional borrowing under the Third Amendment in the nine months ended September 30, 2016. The outstanding principal balance under the Term Loan Agreement was $45.8 million and $30.0 million as of September 30, 2016 and September 30, 2015, respectively. Other income for both periods presented was not significant.

Liquidity and Capital Resources

At September 30, 2016, we had $36.1 million in cash, cash equivalents and short-term investments, which included $2.0 million of restricted cash. We believe that our cash on hand, cash generated from operations, cash available under the Term Loan Agreement, proceeds from the exercise of options and warrants, and proceeds from employee contributions for the purchase of our common stock through our ESPP will be sufficient to satisfy our liquidity requirements for at least the next 12 months.

We expect that our sales performance and the resulting operating income or loss, as well as the status of each of our new product development programs, will significantly impact our cash management decisions. We may also use additional cash for the manufacture of t:slim X2 Pumps to fulfill our obligations under the Technology Upgrade Program, which will be partially offset by any fees we collect under the program.  

We have utilized, and may continue to utilize, debt arrangements with debt providers and financial institutions to finance our operations. Factors such as interest rates, repayment terms and available cash will impact our decision regarding whether to continue to utilize debt arrangements as a source of cash, including whether to draw additional amounts available to us under the Term Loan Agreement. In November 2013, we completed an initial public offering of common stock that resulted in net proceeds of approximately $125.0 million and in the first quarter of 2015 we completed a public offering of common stock that resulted in net proceeds of approximately $64.9 million. In the future, we may give consideration to additional public offerings of equity securities as a source of financing. In December 2014, we filed a registration statement on Form S-3 with the Securities and Exchange Commission, or SEC, which was declared effective on December 19, 2014. Under this shelf registration statement, we may from time to time offer and sell any combination of common stock, preferred stock, warrants or units in one or more offerings.

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The following table shows a summary of our cash flows for the nine months ended September 30, 2016 and 2015:

Operating activities. Net cash used in operating activities was $47.6 million for the nine months ended September 30, 2016, compared to $48.5 million for the same period in 2015. The change in net cash used in operating activities was primarily associated with changes in working capital, offset by the increase in our operating loss. The changes in working capital were primarily due to improvement in cash collections from accounts receivable and an increase in deferred revenue and guarantee liability associated with the Technology Upgrade Program, offset by changes in accounts payable, employee-related liabilities and an increase in inventory to meet higher production volumes, including those associated with new products, and an increase in prepaid expenses.

Investing activities. Net cash provided by investing activities was $5.9 million for the nine months ended September 30, 2016, which was primarily related to the purchase of $25.9 million of short-term investments and $6.2 million of property and equipment, offset by proceeds from sales and maturities of short-term investments of $38.0 million. Net cash used in investing activities was $6.4 million for the nine months ended September 30, 2015, which was primarily related to the net purchase of $67.5 million in short-term investments and $4.1 million of property and equipment, offset by proceeds from sales and maturities of short-term investments of $65.2 million.

Financing activities. Net cash provided by financing activities was $16.6 million for the nine months ended September 30, 2016, which was primarily the result of net proceeds in the amount of $15.0 million in connection with the Third Amendment and $1.6 million in proceeds from the issuance of common stock through our ESPP, as well as the exercise of outstanding stock options and warrants. Net cash provided by financing activities was $67.0 million for the nine months ended September 30, 2015, which was primarily the result of the net proceeds from a public offering of our common stock in the amount of $64.9 million and $2.1 million in proceeds from the issuance of common stock through our ESPP, as well as the exercise of outstanding stock options and warrants.

Our liquidity position and capital requirements are subject to fluctuation based on a number of factors. In particular, our cash inflows and outflows are principally impacted by the following:

Our primary short-term capital needs, which are subject to change, include expenditures related to:

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Although we believe the foregoing items reflect our most likely uses of cash in the short-term, we cannot predict with certainty all of our particular short-term cash uses or the timing or amount of cash used. If cash generated from operations is insufficient to satisfy our working capital and capital expenditure requirements, we may be required to sell additional equity or debt securities or obtain additional credit facilities. If we issue equity securities, our existing stockholders may experience dilution, and the new equity securities may have rights, preferences and privileges senior to those of our existing stockholders. If we issue debt securities or obtain additional credit facilities, we may incur debt service obligations, we may become subject to restrictions limiting our ability to operate our business and we may be required to encumber all or a portion of our assets. There can be no assurance that we will be able to raise any such capital on terms acceptable to us, if at all.

Indebtedness

Term Loan Agreement

At December 31, 2015, we had $30.2 million aggregate borrowings outstanding under the Term Loan Agreement. In January 2016, we entered into a third amendment to our Term Loan Agreement, which allowed us to borrow up to an additional $50.0 million. We borrowed $15.0 million in January 2016, and the Third Amendment provides us with a one-time option to draw up to an additional $35.0 million in increments of $5.0 million on or before December 31, 2016.

Under the Term Loan Agreement, interest is payable, at our option, (i) in cash at a rate of 11.5% per annum or (ii) at a rate of 9.5% of the 11.5% per annum in cash and 2.0% of the 11.5% per annum to be added to the principal of the loan and subject to accruing interest. Interest-only payments are due quarterly on March 31, June 30, September 30 and December 31 of each year of the interest-only payment period, which ends on December 31, 2019. The principal balance is due in full at the end of the term of the loan which is March 31, 2020. The Term Loan Agreement provides for prepayment fees in an amount equal to 1.0% of the outstanding balance of the loan if the loan is repaid prior to March 31, 2017, after which there is no prepayment fee.

We had elected to pay interest in cash at a rate of 11.5% per annum through September 30, 2015. For the nine months ended September 30, 2016 and the three months ended December 31, 2015, we elected to pay interest in cash at a rate of 9.5% per annum and to have a rate of 2.0% per annum added to the principal of the loan. As a result, $675,000 and $153,000 was added to the principal of the loan for the nine months ended September 30, 2016 and the three months ended December 31, 2015, respectively. As of September 30, 2016, we had $45.8 million of aggregate borrowings outstanding under the Term Loan Agreement.

The loan is collateralized by all of our assets. The Term Loan Agreement also imposes various affirmative and negative covenants on us. The principal financial covenants require that we attain minimum annual revenues of $65.0 million in 2016, $80.0 million in 2017 and $95.0 million each year thereafter until the end of the term of the loan. At September 30, 2016, we were in compliance with all of the covenants in the Term Loan Agreement.

Under the Third Amendment, we have agreed to pay, on the earlier of (i) the Maturity Date; (ii) the date that the loan under the Term Loan Agreement becomes due, and (iii) the date on which we make a voluntary pre-payment of the loan, a financing fee equal to three percent (3.0%) of the sum of (x) the aggregate amount drawn under the Third Amendment, and (y) any PIK Loans issued in relation to the Third Amendment.

Critical Accounting Policies

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with U.S. GAAP. The preparation of these financial statements requires management to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses and the disclosure of contingent assets and liabilities in our financial statements. We evaluate our estimates and judgments on an ongoing basis. We base our estimates on 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 our financial condition and results of operations that are not readily apparent from other sources. Actual results may differ from these estimates. There have been no material changes to our critical accounting policies and estimates from the information provided in Part II, Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations – Critical Accounting Policies Involving Management Estimates and Assumptions,” included in our Annual Report on Form 10-K for the year ended December 31, 2015, except for the accounting policies and estimates related to trade-in rights, which is included in note 2 in Part I, Item 1 of this Quarterly Report on Form 10-Q.

Off-Balance Sheet Arrangements

As of September 30, 2016, we did not have any off-balance sheet arrangements.

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We invest our excess cash primarily in commercial paper, government-sponsored enterprise securities and U.S. government treasury securities. Some of the financial instruments in which we invest have market risk associated with them, in that a change in prevailing interest rates may cause the principal amount of the instrument to fluctuate. Other financial instruments in which we invest potentially subject us to credit risk, in that the value of the instrument may fluctuate based on the issuer’s ability to pay.

The primary objectives of our investment activities are to maintain liquidity and preserve principal while maximizing the income we receive from our financial instruments without significantly increasing risk. We have established guidelines regarding approved investments and maturities of investments, which are primarily designed to maintain liquidity and preserve principal.

Because of the short-term maturities of our financial instruments, we do not believe that an increase or decrease in market interest rates would have any significant impact on the realized value of our investment portfolio. If a 10% change in interest rates were to have occurred on September 30, 2016, this change would not have had a material effect on the fair value of our investment portfolio as of that date.

The interest rate under the Term Loan Agreement is fixed and not subject to changes in market interest rates.

Our operations are located in the United States, and nearly all of our sales since inception have been made in U.S. dollars. Accordingly, we do not currently have any material exposure to foreign currency rate fluctuations. From time to time, we may have foreign currency exchange risk associated with currency exposure related to existing assets and liabilities, committed transactions and forecasted future cash flows. In certain circumstances, we may seek to manage such foreign exchange risk by using derivative instruments such as foreign exchange forward contracts to hedge our risks. In general, we may hedge material foreign exchange exposures up to 12 months in advance. However, we may choose not to hedge some exposures for a variety of reasons including prohibitive economic costs.

Evaluation of Disclosure Controls and Procedures

We maintain disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934, as amended (the “Exchange Act”) that are designed to ensure that information required to be disclosed in our periodic and current reports that we file with the SEC is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate, to allow for timely decisions regarding required disclosure. In designing and evaluating the disclosure controls and procedures, management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable and not absolute assurance of achieving the desired control objectives. In reaching a reasonable level of assurance, management necessarily is required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures. In addition, the design of any system of controls is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions, or the degree of compliance with policies or procedures may deteriorate. Control systems can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

As of September 30, 2016, we carried out an evaluation, under the supervision and with the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures. Based on this evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures were effective at the reasonable assurance level as of September 30, 2016.

Changes in Internal Control over Financial Reporting

During the three months ended September 30, 2016, we developed and implemented new control procedures over financial reporting for the Technology Upgrade Program.

Except as described above, there were no changes in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Exchange Act) during the quarter ended September 30, 2016 that 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 various legal proceedings, disputes and other claims arising in the ordinary course of our business. Although the results of legal proceedings and claims cannot be predicted with certainty, we currently believe that the final outcome of these ordinary course matters will not, individually or in the aggregate, have a material adverse effect on our business, financial position, results of operations or cash flows. However, regardless of the outcome, legal proceedings can have an adverse impact on us because of legal costs, diversion of management time and resources, and other factors.

Item 1A. Risk Factors

The following sets forth certain risk factors associated with our business. The risk factors set forth below marked with an asterisk (*) next to the title contain changes to the description of the risk factors associated with our business previously disclosed in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2015.

An investment in our common stock involves risks. You should consider carefully the risks described below, together with all of the other information included in this Quarterly Report, as well as in our other filings with the SEC, in evaluating our business. If any of the following risks actually occur, our business, financial condition, operating results and future prospects could be materially and adversely affected. In that case, the trading price of our common stock may decline and you might lose all or part of your investment. The risks described below are not the only ones we face. Additional risks that we currently do not know about or that we currently believe to be immaterial may also impair our business, financial condition, operating results and prospects. Certain statements below are forward-looking statements.

Risks Relating to Our Business and our Industry

We have incurred significant operating losses since inception and cannot assure you that we will achieve profitability. *

Since our inception in January 2006 we have incurred a significant net loss. As of September 30, 2016, we had an accumulated deficit of $389.8 million. To date, we have financed our operations primarily through public and private sales of our equity securities, debt financing with Capital Royalty Partners II L.P. and its affiliated funds, or Capital Royalty Partners, and sales of our products. We have devoted substantially all of our resources to the research and development of our products, the scaling of manufacturing operations and our commercial organization, the commercial launches of our products, and the assembly of a management team to manage our business.

We began commercial sales of our first commercial product, the t:slim Pump, in the third quarter of 2012. We began commercial sales of the t:flex Pump in the second quarter of 2015 and the t:slim G4 Pump in the third quarter of 2015. In October 2016 we discontinued new shipments of our original t:slim Pump and launched a next-generation pump under the t:slim X2 name. Since the first quarter of 2013, we have been able to manufacture and sell our insulin pump products at a cost and in volumes sufficient to allow us to achieve a positive overall gross margin. For the years ended December 31, 2015 and 2014, our gross profit was $26.6 million and $15.2 million, respectively. For the three months ended September 30, 2016 and 2015, our gross profit (loss) was $(1.6) million and $5.5 million, respectively. Although we have achieved a positive overall gross margin, we still operate at a substantial net loss and expect that we will continue to do so for the next several years.

To implement our business strategy we need to, among other things, grow our sales, clinical and marketing infrastructure to increase sales of our products, fund ongoing research and development activities, expand our manufacturing capabilities, and obtain regulatory clearance or approval to commercialize our products currently under development. We expect our expenses to increase significantly as we pursue these objectives. The extent of our future operating losses and the timing of profitability are highly uncertain, especially given that we intend to launch several new products and product features over the next several years. In addition, the Technology Upgrade Program makes forecasting our sales more difficult, because such forecasts depend on customer behavioral assumptions, such as the likelihood that the trade-in rights will be exercised. Any additional operating losses will have an adverse effect on our stockholders’ equity, and we cannot assure you that we will ever be able to achieve or sustain profitability.

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The administration of the Technology Upgrade Program may result in unanticipated difficulties or costs, which may harm our financial condition or operating results; the Technology Upgrade Program will result in accounting complexities that may be difficult for investors to understand and may lead to confusion when comparing our historical and future financial results. *

In July 2016, we announced the implementation of a Technology Upgrade Program that allows eligible t:slim and t:slim G4 Pump customers the ability to trade in their existing pump for a t:slim X2 Pump, subject to the conditions specified in the Technology Upgrade Program. The Technology Upgrade Program is being offered to provide our existing customers the ability to upgrade to the features and capabilities of the t:slim X2 Pump. However, we do not have experience implementing and administering trade-in programs of this type and we may encounter unexpected difficulties or costs in administering or fulfilling our obligations under the Technology Upgrade Program.

If we incur unexpected difficulties or costs in administering the Technology Upgrade Program, or if we do not derive the anticipated benefits to our business from offering the Technology Upgrade Program to our customers, it could have a material adverse effect on our financial condition and operating results.

Furthermore, the Technology Upgrade Program will result in a number of accounting complexities that will make comparisons of our future and historical financial results more difficult. In particular, United States generally accepted accounting principles, or GAAP, prevents us from recognizing, at the time of sale, the full amount of the revenue and cost of goods sold associated with the sale of t:slim and t:slim G4 Pumps made to eligible customers during the Technology Upgrade Program. Instead, depending on the type of pump sold, we will be required to defer some or all of the revenues and costs of goods sold until a later date, which will generally be the earlier of when our obligations under the Technology Upgrade Program are satisfied or when the Technology Upgrade Program expires. The amount and timing of the deferred revenues and cost of goods sold will depend on multiple factors that are based on future events that are difficult to estimate or predict, especially because we have not offered a similar trade-in program in the past. For example, we do not currently have sufficient history to reasonably estimate returns associated with the trade-in rights (a factor of the accounting analysis with respect to the t:slim Pump) or the likelihood that the trade-in rights will be exercised (a factor of the accounting analysis with respect to the t:slim G4 Pump). Accordingly, it is very difficult for us to estimate the amount of the deferrals with any level of certainty, which makes it very difficult for us to predict our GAAP results, including revenues and operating margins.

Despite our efforts to explain the anticipated accounting treatment, it is possible that investors or analysts will view the accounting treatment or the resulting impact on our GAAP financial results negatively, or it may lead to confusion when comparing our historical and future financial results, which may cause our stock price to decline. In addition, the complexities associated with the accounting treatment, or with the Technology Upgrade Program generally, may cause investors to avoid purchasing our common stock until the impact of the Technology Upgrade Program is better understood or the Company financial results and trends are more predictable, which also may adversely impact our stock price. Finally, while the anticipated accounting treatment for the Technology Upgrade Program as described above represents our current expectations based on information currently available, it is preliminary and subject to change in the future.

Our ability to achieve profitability will depend, in part, on our ability to reduce the per unit cost of our products by increasing production volume and manufacturing efficiency, including by reducing raw material, labor, product-training, expected warranty and manufacturing overhead costs per unit. *

We believe that our ability to reduce the per-unit cost of our insulin pump products and related cartridges will have a significant impact on our ability to achieve profitability. Due to our existing production volumes relative to our potential production capacity, manufacturing costs are currently a significant portion of our per-unit costs. Our manufacturing costs include raw material procurement costs, labor costs, product-training expenses and expected warranty expenses. They also include manufacturing overhead costs, including expenses relating to quality assurance, inventory control, facilities, equipment, information technology, and operations management. If we are unable to sustain or reduce our overall manufacturing costs, including through arrangements such as volume purchase discounts, negotiation of improved pricing, more efficient training programs for customers, and improved warranty performance, it will be difficult to reduce our per unit manufacturing costs and our ability to achieve profitability will be constrained. The per unit cost of our products is significantly impacted by our overall production volumes, and any factors that cause our production volumes to decline, or to grow at a slower rate than we expect, would significantly impact our expected per unit costs. In addition, we may experience disruption in our manufacturing productivity or incur duplicative or incremental costs as we manage the planned relocation of our manufacturing facility. Furthermore, while we currently believe our proprietary technology platform will allow us to gain efficiencies in the design and development of new products, changes in the market that require us to modify or replace our existing platform will reduce the amount of efficiency gained through our platform and increase our expected per unit costs. If we are unable to effectively manage our overall manufacturing costs, while increasing our production volumes, we may not be able to achieve or sustain profitability, which would have an adverse impact on our business and financial condition.  

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We currently rely on sales of insulin pumps to generate a significant portion of our revenue, and any factors that negatively impact sales of our insulin pump products may adversely affect our business, financial condition and operating results. *

We generate a significant majority of our commercial revenue from the sale of our family of insulin pump products, which include our t:slim, t:flex and t:slim G4 products.

Sales of our insulin pumps may be negatively impacted by many factors, including:

In addition, sales of any of our current or future insulin pump products with integration of CGM, such as the t:slim G4, are subject to the continuation of our applicable agreements with DexCom, which are subject to termination by DexCom, with or without cause, on relatively short notice.

Because we currently rely on sales of our insulin pump products to generate a significant majority of our revenue, any factors that negatively impact sales of these products, or result in sales of these products increasing at a lower rate than expected, could adversely affect our business, financial condition and operating results and negatively impact our ability to successfully launch future products currently under development.

The failure of our products to achieve and maintain market acceptance could result in us achieving sales below our expectations, which would cause our business, financial condition and operating results to be materially and adversely affected. *

Our current business strategy is highly dependent on our family of insulin pump products, which include t:slim, t:flex and t:slim G4, achieving and maintaining market acceptance. In order for us to sell our products to people with insulin-dependent diabetes, we must convince them, their caregivers and healthcare providers that it is an attractive alternative to competitive products for the treatment of diabetes, including traditional insulin pump products and MDI therapies, as well as alternative insulin treatment methodologies. Market acceptance and adoption of our products depends on educating people with diabetes, as well as their caregivers and healthcare providers, as to the distinct features, ease-of-use, positive lifestyle impact, and other perceived benefits of our products as compared to competitive products. If we are not successful in convincing existing and potential customers of the benefits of our products, or if we are not able to achieve the support of caregivers and healthcare providers for our insulin pump products, our sales may decline or we may fail to increase our sales in line with our forecasts.

Achieving and maintaining market acceptance of our products could be negatively impacted by many factors, including:

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In addition, t:slim, t:flex and t:slim G4 may be perceived by people with insulin-dependent diabetes, their caregivers or healthcare providers to be more complicated, less reliable or less effective than traditional insulin therapies, including MDI, and people may be unwilling to change their current treatment regimens.

Moreover, we believe that healthcare providers tend to be slow to change their medical treatment practices because of perceived liability risks arising from the use of new products and the uncertainty of third-party reimbursement. Accordingly, healthcare providers may not recommend our products until there is sufficient evidence to convince them to alter the treatment methods they typically recommend, such as receiving recommendations from prominent healthcare providers or other key opinion leaders in the diabetes treatment community that our products are effective in providing insulin therapy. Additionally, payors may have more stringent requirements for reimbursement.

Further, even if we are able to convince people with insulin-dependent diabetes, their caregivers or healthcare providers that our products compare favorably to the products and treatment alternatives offered by our competitors, the rapid evolution of technology and treatment options within our industry may cause consumers to delay the purchase of our products in anticipation of advancements, or the perception that advancements could occur, in our products or the products offered by our competitors. For example, we believe that during the third quarter of 2016, there were consumers interested in purchasing one of our insulin pump products who may have delayed the purchase decision in anticipation of the release of t:slim X2 or of a new product being launched by one of our competitors. It is also possible that consumers interested in purchasing any of our future products currently in development may delay the purchase of one of our current products.

If our insulin pump products do not achieve and maintain widespread market acceptance, we may fail to achieve sales at or above our projected amounts. If our sales do not meet our projections, we may fail to meet our strategic objectives, and our business, financial condition and operating results could be materially and adversely affected.

Failure to secure or retain adequate coverage or reimbursement for our current products and our potential future products by third-party payors could adversely affect our business, financial condition and operating results. *

We have derived nearly all of our revenue from sales of insulin pumps and associated supplies, and expect to continue to do so until we are able to commercialize our other products that are currently under development. A substantial portion of the purchase price of an insulin pump is typically paid for by third-party payors, including private insurance companies, preferred provider organizations and other managed care providers. Future sales of our current and future products will be limited unless our customers can rely on third-party payors to pay for all or part of the associated purchase cost. Because we only recently initiated commercial sales of t:flex and t:slim G4, there remains some uncertainty regarding the coverage that third-party payors will offer for these products, particularly for individuals with type 2 diabetes where coverage requirements may necessitate additional laboratory tests or other information to support a determination of medical necessity. Access to adequate coverage and reimbursement for our current and future products by third-party payors is essential to the acceptance of our products by customers.

Many third-party payors use coverage decisions and payment amounts determined by the Centers for Medicare and Medicaid Services, or CMS, which administers the U.S. Medicare program, as guidelines in setting their coverage and reimbursement policies. Medicare periodically reviews its reimbursement practices for diabetes-related products. Medicare implemented a competitive bidding process for blood glucose strip reimbursement, which resulted in a significant reduction in the reimbursement rate for those products. More recently, Medicare has also initiated a competitive bidding process for insulin pumps in limited geographies. As a result, there is uncertainty as to the future Medicare reimbursement rate for our products. In addition, those third-party payors that do not follow the CMS guidelines may adopt different coverage and reimbursement policies for our current and future products. It is possible that some third-party payors will not offer any coverage for our current or future products. For instance, effective July 1, 2016, UnitedHealthcare designated one of our competitors as their preferred, in-network durable medical equipment provider of insulin pumps for most customers over the age of 18. We expect this decision will prevent a majority of UnitedHealthcare members from purchasing an insulin pump from us for the foreseeable future. It is possible that other payors may adopt similar policies in the future, which would adversely impact our ability to sell our products.

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We currently have contracts establishing reimbursement for our insulin pump products with approximately 156 national and regional third-party payors in the United States. While we anticipate entering into additional contracts with third-party payors and adding coverage for future products under our current agreements, we cannot guarantee that we will succeed in doing so or that the reimbursement contracts that we are able to negotiate will enable us to sell our products on a profitable basis. In addition, contracts with third-party payors generally can be modified or terminated by the third-party payor without cause and with little or no notice to us. Moreover, compliance with the administrative procedures or requirements of third-party payors may result in delays in processing approvals by those third-party payors for customers to obtain coverage for our products. Failure to secure or retain adequate coverage or reimbursement for our current and future products by third-party payors, or delays in processing approvals by those payors, could result in the loss of sales, which could have a material adverse effect on our business, financial condition and operating results.

Further, the healthcare industry in the United States is increasingly focused on cost containment as government and private insurers seek to control healthcare costs by imposing lower payment rates and negotiating reduced contract rates with third-party payors. If third-party payors deny coverage or reduce their current levels of payment, or if our production costs increase faster than increases in reimbursement levels, we may be unable to sell our products on a profitable basis.

We operate in a very competitive industry and if we fail to compete successfully against our existing or potential competitors, many of whom have greater resources than us, our sales and operating results may be negatively affected. *

The medical device industry is intensely competitive, subject to rapid change and highly sensitive to the introduction of new products or technologies, or other activities of industry participants. We expect our products will compete directly with a number of traditional insulin pumps as well as other methods for the treatment of diabetes. In particular, we expect that the competitive landscape for t:flex, t:slim G4 and our products under development will be similar to that of t:slim.

Many of our existing and potential competitors are major medical device companies that are either publicly traded companies or divisions or subsidiaries of publicly traded companies. For instance, Medtronic MiniMed, a division of Medtronic, Inc., has been the market leader for many years and has the majority share of the traditional insulin pump market in the United States. Other significant insulin pump suppliers in the United States include Animas Corporation, a division of Johnson & Johnson, and Insulet Corporation. There are also newer companies entering the field.

Many of these more established competitors enjoy several competitive advantages over us, including: