Vanda Pharmaceuticals Inc. - Quarter Report: 2014 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

For the quarterly period ended September 30, 2014

or

For the transition period from                      to                     

Commission File Number: 001-34186

VANDA PHARMACEUTICALS INC.

(Exact name of registrant as specified in its charter)

(202) 734-3400

(Registrant’s telephone number, including area code)

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or 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  x    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  x    No  ¨

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

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

As of October 22, 2014, there were 33,901,084 shares of the registrant’s common stock issued and outstanding.

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Vanda Pharmaceuticals Inc.

Quarterly Report on Form 10-Q

For the Quarter Ended September 30, 2014

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Part I — FINANCIAL INFORMATION

ITEM 1 Financial Statements (Unaudited)

VANDA PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (Unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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VANDA PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (Unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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VANDA PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (Unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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VANDA PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY (Unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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VANDA PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (Unaudited)

The accompanying notes are an integral part of these unaudited condensed consolidated financial statements.

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VANDA PHARMACEUTICALS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)

1. Business Organization and Presentation

Business organization

Vanda Pharmaceuticals Inc. (Vanda or the Company) is a biopharmaceutical company focused on the development and commercialization of products for the treatment of central nervous system disorders. Vanda commenced its operations in 2003. Vanda’s product portfolio includes HETLIOZ^® (tasimelteon), a product for the treatment of Non-24-Hour Sleep-Wake Disorder (Non-24) for which a New Drug Application (NDA) was approved by the U.S. Food and Drug Administration (FDA) in January 2014 and launched commercially in the U.S. in April 2014, Fanapt^®(iloperidone), a product for the treatment of schizophrenia, the oral formulation of which is being marketed and sold in the U.S. by Novartis Pharma AG (Novartis), launched in Israel by the Company’s distribution partners and expected to be launched in Mexico by the Company’s distribution partner in the fourth quarter of 2014, and VLY-686, a small molecule neurokinin-1 receptor (NK-1R) antagonist.

Basis of presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by GAAP for complete financial statements and should be read in conjunction with the Company’s consolidated financial statements for the fiscal year ended December 31, 2013 included in the Company’s annual report on Form 10-K. The financial information as of September 30, 2014 and for the three and nine months ended September 30, 2014 and 2013 is unaudited, but in the opinion of management, all adjustments with the exception of stock-based compensation expense, see Note 3, Change in Method of Accounting for Stock-based Compensation, consist only of normal recurring accruals, considered necessary for a fair statement of the results of these interim periods have been included. The condensed consolidated balance sheet data as of December 31, 2013 was derived from audited financial statements but does not include all disclosures required by GAAP.

The results of the Company’s operations for any interim period are not necessarily indicative of the results that may be expected for any other interim period or for a full fiscal year. The financial information included herein should be read in conjunction with the consolidated financial statements and notes in the Company’s annual report on Form 10-K for the fiscal year ended December 31, 2013.

2. Summary of Significant Accounting Policies

Use of estimates

The preparation of financial statements in conformity with GAAP requires management to make estimates that affect the reported amounts of assets and liabilities at the date of the financial statements, disclosure of contingent assets and liabilities, and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

Inventory

Inventory, which is recorded at the lower of cost or market, includes the cost of third-party manufacturing and other direct and indirect costs and is valued using the first-in, first-out method. The Company capitalizes inventory costs associated with its products upon regulatory approval when, based on management’s judgment, future commercialization is considered probable and the future economic benefit is expected to be realized; otherwise, such costs are expensed as research and development. Inventory is evaluated for impairment by consideration of factors such as lower of cost or market, net realizable value, obsolescence or expiry.

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Net Product Revenues

The Company’s 2014 net product revenues consist of U.S. sales of HETLIOZ^® for the treatment of Non-24 and sales of Fanapt^® in Israel. The Company applies the revenue recognition guidance in accordance with Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) Subtopic 605-15, Revenue Recognition—Products. The Company recognizes revenue from product sales when there is persuasive evidence that an arrangement exists, title to product and associated risk of loss has passed to the customer, the price is fixed or determinable, collectability is reasonably assured and the Company has no further performance obligations.

In the U.S., HETLIOZ^® is only available for distribution through a limited number of specialty pharmacies, and is not available in retail pharmacies. In April 2014, the Company launched HETLIOZSolutions™ to support and facilitate the treatment of blind individuals in the U.S. living with Non-24. HETLIOZSolutions™ provides patients with a host of resources including information about Non-24 and HETLIOZ^®, insurance support, overview of financial assistance programs and pharmacy access. The Company invoices and records revenue when the specialty pharmacies receive HETLIOZ^® from the third-party logistics warehouse.

The Company has entered into distribution agreements with Probiomed S.A. de C.V. (Probiomed) for the commercialization of Fanapt^® in Mexico and Megapharm Ltd. for the commercialization of Fanapt^® in Israel. With the exception of sales to Probiomed, the Company invoices and records revenue upon delivery of Fanapt^® to the distribution partner. The Probiomed distribution agreement contains a contracted delivery price plus a revenue sharing provision based on Probiomed’s sales of Fanapt^®. As a result, the selling price of Fanapt^® is not fixed or determinable upon delivery of Fanapt^® to Probiomed. The Company defers revenue recognition until the revenue sharing provision is calculated, which is approximately 45-days following the end of the calendar quarter. As of September 30, 2014, the Company recorded $0.2 million of deferred revenue related to Fanapt^® sales.

Product Sales Discounts and Allowances

HETLIOZ^® product sales revenue is recorded net of applicable discounts, chargebacks, rebates, co-pay assistance, service fees and product returns that are applicable for various government and commercial payors. Reserves established for discounts and returns are classified as reductions of accounts receivable if the amount is payable to direct customers, with the exception of service fees. Service fees are classified as a liability. Reserves established for chargebacks, rebates or co-pay assistance are classified as a liability if the amount is payable to a party other than customers. The Company currently records sales allowances for the following:

Rebates: Allowances for rebates include mandated discounts under the Medicaid Drug Rebate Program. Rebate amounts owed after the final dispensing of the product to a benefit plan participant are based upon contractual agreements or legal requirements with public sector benefit providers, such as Medicaid. The allowance for rebates is based on statutory discount rates and expected utilization. Estimates for the expected utilization of rebates are based in part on actual and pending prescriptions for which the Company has validated the insurance benefits. Rebates are generally invoiced and paid in arrears, such that the accrual balance consists of an estimate of the amount expected to be incurred for the current quarter’s activity, plus an accrual balance for known prior quarter’s unpaid rebates.

Chargebacks: Chargebacks are discounts that occur when contracted customers purchase directly from specialty pharmacies. Contracted customers, which currently consist primarily of Public Health Service institutions, non-profit clinics, and Federal government entities purchasing via the Federal Supply Schedule, generally purchase the product at a discounted price. The specialty pharmacy, in turn, charges back the difference between the price initially paid by the specialty pharmacy and the discounted price paid to the specialty pharmacy by the contracted customer. The allowance for chargebacks is based on actual and pending prescriptions for which the Company has validated the insurance benefits.

Medicare Part D Coverage Gap: Medicare Part D prescription drug benefit mandates manufacturers to fund approximately 50% of the Medicare Part D insurance coverage gap for prescription drugs sold to eligible patients. Estimates for expected Medicare Part D coverage gap are based in part on historical invoices received and on actual and pending prescriptions for which the Company has validated the insurance benefits. Funding of the coverage gap is generally invoiced and paid in arrears so that the accrual balance consists of an estimate of the amount expected to be incurred for the current quarter’s activity, plus an accrual balance for known prior quarter activity. If actual future funding varies from estimates, the Company may need to adjust accruals, which would affect net revenue in the period of adjustment.

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Service Fees: The Company also incurs specialty pharmacy fees for services and their data. These fees are based on contracted terms and are known amounts. The Company accrues service fees at the time of revenue recognition, resulting in a reduction of product sales revenue and the recognition of an accrued liability, unless it receives an identifiable and separate benefit for the consideration and it can reasonably estimate the fair value of the benefit received. In which case, service fees are recorded as selling, general and administrative expense.

Co-payment Assistance: Patients who have commercial insurance and meet certain eligibility requirements may receive co-payment assistance. Co-pay assistance utilization is based on information provided by the Company’s third-party administrator. The allowance for co-pay assistance is based on actual and pending sales for which the Company has validated the insurance benefits.

Prompt-pay: Specialty pharmacies are offered discounts for prompt payment. The Company expects that the specialty pharmacy will earn prompt payment discounts and, therefore, deducts the full amount of these discounts from total product sales when revenues are recognized.

Product Returns: Consistent with industry practice, the Company generally offers direct customers a limited right to return as defined within the Company’s returns policy. The Company considers several factors in the estimation process, including expiration dates of product shipped to specialty pharmacies, inventory levels within the distribution channel, product shelf life, prescription trends and other relevant factors.

There were no discounts or rebates associated with Fanapt^® product revenue recognized in the period. The Company’s partners have a limited right to return Fanapt^®. Once Fanapt^® has been delivered to the partners it generally may not be returned for any reason other than product recall.

Stock-based Compensation

In January 2014, the Company elected to change its method of accounting for the attribution of compensation cost for stock options with graded-vesting and only service conditions to the straight-line method. Previously, attribution was based on the accelerated attribution method, which treated each vesting tranche as an individual award and amortized them concurrently. Comparative financial statements for prior periods have been adjusted to apply the straight-line method retrospectively. See Note 3, Change in Method of Accounting for Stock-based Compensation, for further information. Beginning in 2014, the Company started using a mid-point scenario to calculate the weighted average expected term of stock options granted, which combines the Company’s historical exercise data with hypothetical exercise data for unexercised stock options. Prior to 2014, the expected term assumption was determined using the simplified method.

Advertising Expense

The Company expenses the costs of advertising, including branded promotional expenses, as incurred. Branded advertising expenses, recorded in selling, general and administrative expenses, were $0.3 million and $4.6 million for the three and nine months ended September 30, 2014, respectively. The Company did not incur any advertising expense during the nine months ended September 30, 2013.

Recent accounting pronouncements

In August 2014, the FASB issued Accounting Standard Update (ASU) 2014-15, Presentation of Financial Statements – Going Concern. The new standard requires management of public and private companies to evaluate whether there is substantial doubt about the entity’s ability to continue as a going concern and, if so, disclose that fact. Management will also be required to evaluate and disclose whether its plans alleviate that doubt. The new standard is effective for annual periods ending after December 15, 2016, and interim periods within annual periods beginning after December 15, 2016.

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (Topic 606). This new standards requires companies to recognize revenue when it transfers promised goods or services to customers in an amount that reflects the

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consideration to which a company expects to be entitled in exchange for those goods or services. Under the new standard, revenue is recognized when a customer obtains control of a good or service. The standard allows for two transition methods - entities can either apply the new standard (i) retrospectively to each prior reporting period presented, or (ii) retrospectively with the cumulative effect of initially applying the standard recognized at the date of initial adoption. The new standard is effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption of the standard is prohibited. The Company is evaluating this standard to determine if adoption will have a material impact on the Company’s condensed consolidated financial statements.

In July 2013, the FASB issued ASU 2013-11, Income Taxes (Topic 740): Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists. This new standard requires the netting of unrecognized tax benefits against a deferred tax asset for a loss or other carryforward that would apply in settlement of the uncertain tax positions. Under the new standard, unrecognized tax benefits will be netted against all available same-jurisdiction loss or other tax carryforwards that would be utilized, rather than only against carryforwards that are created by the unrecognized tax benefits. The new standard is effective for public companies for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2013. Adoption of this new standard did not have a material impact on the Company’s condensed consolidated financial statements.

3. Change in Method of Accounting for Stock-based Compensation

In January 2014, the Company elected to change its method of accounting for the attribution of compensation cost for stock options with graded-vesting and only service conditions to the straight-line method. Previously, attribution was based on the accelerated attribution method, which treated each vesting tranche as an individual award and amortized them concurrently. The straight-line method of accounting was adopted to better align the Company’s recognition of stock option compensation cost with its peers and to expense stock options and restricted stock units (RSUs) in a consistent manner. Comparative financial statements for prior periods have been adjusted to apply the straight-line method retrospectively. As a result of the change in method of accounting for stock-based compensation, the expense for stock-based compensation related to option awards was $0.4 million and $1.6 million lower than it would have been under the accelerated attribution method for the three and nine months ended September 30, 2014, respectively. This resulted in a reduction to the net loss of $0.4 million and $1.6 million, or $0.01 per share and $0.05 per share, respectively, for the three and nine months ended September 30, 2014.

There was no adjustment as a result of the change in method of accounting for stock-based compensation to amounts previously reported as assets, liabilities and total stockholders’ equity in the consolidated balance sheets for prior periods. However, amounts previously reported as additional paid-in capital and accumulated deficit for prior periods have been adjusted to reflect the change in method of accounting for stock-based compensation. The cumulative effect of the change on accumulated deficit as of January 1, 2013, the beginning of the earliest period presented in the financial statements was a reduction of $3.2 million. The adjustments as of December 31, 2013 were as follows:

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The amounts previously reported in the consolidated statement of operations for research and development expense, selling, general and administrative expense and net loss for prior periods have been adjusted as a result of the change in method of accounting for stock-based compensation. The adjustments for the three and nine months ended September 30, 2013 were as follows:

The amounts previously reported for net loss in the consolidated statement of comprehensive loss for prior periods have been adjusted as a result of the change in method of accounting for stock-based compensation. The adjustment for the three and nine months ended September 30, 2013 was as follows:

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There was no adjustment to the amounts previously reported for net cash used in operating activities in the consolidated statements of cash flows for prior periods as a result of the change in method of accounting for stock-based compensation. However, the amounts previously reported as net loss and employee and non-employee stock-based compensation expense in cash flows from operating activities have been adjusted to reflect the change in method of accounting for stock-based compensation. The adjustments for the nine months ended September 30, 2013 were as follows:

4. Earnings per Share

Basic earnings per share (EPS) is calculated by dividing the net income (loss) by the weighted average number of shares of common stock outstanding. Diluted EPS is computed by dividing the net income (loss) by the weighted average number of shares of common stock outstanding, plus potential outstanding common stock for the period. Potential outstanding common stock includes stock options and shares underlying RSUs, but only to the extent that their inclusion is dilutive.

The following table presents the calculation of basic and diluted net loss per share of common stock for the three and nine months ended September 30, 2014 and 2013:

The Company incurred net losses for the three and nine months ended September 30, 2014 and 2013 causing inclusion of any potentially dilutive securities to have an anti-dilutive effect, resulting in dilutive loss per share and basic loss per share attributable to common stockholders being equivalent.

5. Marketable Securities

The following is a summary of the Company’s available-for-sale marketable securities as of September 30, 2014, which all have contract maturities of less than one year:

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The following is a summary of the Company’s available-for-sale marketable securities as of December 31, 2013:

6. Fair Value Measurements

Authoritative guidance establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. These tiers include:

Marketable securities classified in Level 1 and Level 2 as of September 30, 2014 and December 31, 2013 consist of available-for-sale marketable securities. The valuation of Level 1 instruments is determined using a market approach, and is based upon unadjusted quoted prices for identical assets in active markets. The valuation of investments classified in Level 2 also is determined using a market approach based upon quoted prices for similar assets in active markets, or other inputs that are observable for substantially the full term of the financial instrument. Level 2 securities include certificates of deposit, commercial paper and corporate notes that use as their basis readily observable market parameters. The Company did not transfer any assets between Level 2 and Level 1 during the nine months ended September 30, 2014.

As of September 30, 2014, the Company held certain assets that are required to be measured at fair value on a recurring basis, as follows:

As of December 31, 2013, the Company held certain assets that are required to be measured at fair value on a recurring basis, as follows:

The Company also has financial assets and liabilities, not required to be measured at fair value on a recurring basis, which primarily consist of cash and cash equivalents, accounts receivable, restricted cash, accounts payable and accrued liabilities, the carrying value of which materially approximate their fair values.

7. Inventory

The Company evaluates expiry risk by evaluating current and future product demand relative to product shelf life. The Company builds demand forecasts by considering factors such as, but not limited to, overall market potential, market share, market acceptance and patient usage. Inventory consisted of the following as of September 30, 2014 and December 31, 2013:

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Deferred cost of goods sold represents the cost of product shipped to Probiomed, for which revenue recognition has been deferred. See Note 2, Summary of Significant Accounting Policies, for a discussion of Fanapt^® revenue recognition.

8. Prepaid Expenses and Other Current Assets

The following is a summary of the Company’s prepaid expenses and other current assets as of September 30, 2014 and December 31, 2013:

9. Intangible Assets

The following is a summary of the Company’s intangible asset as of September 30, 2014:

The following is a summary of the Company’s intangible asset as of December 31, 2013:

In January 2014, the Company announced that the FDA had approved the NDA for HETLIOZ^®. As a result of this approval, the Company met a milestone under its license agreement with Bristol-Myers Squibb (BMS) that required the Company to make a license payment of $8.0 million to BMS. The $8.0 million is being amortized on a straight-line basis over the remaining life of the U.S. patent for HETLIOZ^®, which prior to June 2014, the Company expected to last until December 2022. In June 2014, the Company received a notice of allowance from the U.S. Patent and Trademark Office for a patent covering the method of use of HETLIOZ^®. The patent expires in January 2033, thereby potentially extending the exclusivity protection in the U.S. beyond the composition of matter patent. As a result of the patent allowance, the Company extended the estimated useful life of the U.S. patent for HETLIOZ^® from December 2022 to January 2033.

In 2009, the Company announced that the FDA had approved the NDA for Fanapt^®. As a result of this approval, the Company met a milestone under its original sublicense agreement with Novartis that required the Company to make a license payment of $12.0 million to Novartis. The $12.0 million is being amortized on a straight-line basis over the remaining life of the U.S. patent for Fanapt^®, which as of December 31, 2013 the Company expected to last until May 2017. In 2014, the Company became aware of events that led it to believe that Novartis would not complete the ongoing pediatric efficacy studies in a time that would enable it to receive the incremental six-month pediatric term extension. This resulted in a six-month reduction to the estimated patent life from May 2017 to November 2016.

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The intangible assets are being amortized over their estimated useful economic life using the straight-line method. Amortization expense was $0.5 million and $0.4 million for the three months ended September 30, 2014 and 2013, respectively. Amortization expense was $1.7 million and $1.1 million for the nine months ended September 30, 2014 and 2013, respectively. The following is a summary of future intangible asset amortization as of September 30, 2014:

10. Accrued Liabilities

The following is a summary of the Company’s accrued liabilities as of September 30, 2014 and December 31, 2013:

11. Deferred Revenue

The following is a summary of changes in total deferred revenue for the nine months ended September 30, 2014 and 2013:

The Company entered into an amended and restated sublicense agreement with Novartis in 2009, pursuant to which Novartis has the right to commercialize and develop Fanapt^® in the U.S. and Canada. Under the amended and restated sublicense agreement, the Company received an upfront payment of $200.0 million. The Company and Novartis established a Joint Steering Committee (JSC) following the effective date of the amended and restated sublicense agreement. The Company concluded that the JSC constitutes a deliverable under the amended and restated sublicense agreement and that revenue related to the upfront payment will be recognized ratably over the term of the JSC; however, the delivery or performance has no term as the exact length of the JSC is undefined. As a result, the Company deems the performance period of the JSC to be the life of the U.S. patent of Fanapt^®. Revenue related to the upfront payment will be recognized ratably from the date the amended and restated sublicense agreement became effective (November 2009) through the expected life of the U.S. patent for Fanapt^® (November 2016). See Note 9 Intangible Assets, for a discussion of the Fanapt^® patent life.

12. Income Taxes

Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The fact that the Company has historically generated net operating losses (NOLs) serves as strong evidence that it is more likely than not that deferred tax assets will not be realized in the future. Therefore, the Company has a full valuation allowance against all deferred tax assets as of September 30, 2014 and December 31, 2013. Changes in ownership may limit the amount of NOL carryforwards that can be utilized in the future to offset taxable income.

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13. Commitments and Contingencies

Operating leases

In 2011, the Company entered into an office lease with Square 54 Office Owner LLC (the Landlord) for its current headquarters, consisting of 21,400 square feet at 2200 Pennsylvania Avenue, N.W. in Washington, D.C. (the Lease). Subject to the prior rights of other tenants in the building, the Company has the right to renew the Lease for five years following the expiration of its original term. The Company has the right to sublease or assign all or a portion of the premises, subject to standard conditions. The Lease may be terminated early by the Company or the Landlord upon certain conditions.

In March 2014, the Company and the Landlord entered into a lease amendment (the Lease Amendment). Under the Lease Amendment, the Company has the right to occupy an additional 8,860 square feet in the building. The Lease Amendment has a 12 year and one month term beginning on September 1, 2014, but may be terminated early by either the Landlord or the Company upon certain conditions. The Company will pay approximately $0.4 million in annual rent over the term of the Lease Amendment, however, rent will be abated for the first nine months. The Landlord will provide the Company with an allowance of approximately $0.8 million for construction on the premises to the Company’s specifications, subject to certain conditions. Subject to the prior rights of other tenants in the building, the Company will have the right to renew the Lease Amendment for five years following the expiration of its original term. The Company will also have the right to sublease or assign all or a portion of the premises, subject to standard conditions.

The following is a summary of the minimum annual future payments under operating leases as of September 30, 2014:

Rent expense under operating leases, was $0.4 million and $0.3 million for the three months ended September 30, 2014 and 2013, respectively. Rent expense under operating leases, was $1.2 million and $0.8 million for the nine months ended September 30, 2014 and 2013, respectively.

Consulting fees

The Company engaged a regulatory consultant to assist the Company’s efforts to prepare, file and obtain FDA approval of an NDA for HETLIOZ^®. As a result of the FDA approval of the NDA for HETLIOZ^®, the Company made a milestone payment of $2.0 million, which is included in research and development expenses in the consolidated statement of operations for the nine months ended September 30, 2014. In March 2014, the Company terminated the engagement.

License agreements

The Company’s rights to develop and commercialize its products are subject to the terms and conditions of licenses granted to the Company by other pharmaceutical companies.

HETLIOZ^®. In February 2004, the Company entered into a license agreement with BMS under which the Company received an exclusive worldwide license under certain patents and patent applications, and other licenses to intellectual property, to develop and commercialize HETLIOZ^®. As a result of the FDA approval of the NDA for HETLIOZ^® in January 2014, the Company made a milestone payment of $8.0 million in the first quarter of 2014. The Company will be obligated to make a future milestone payment to BMS of up to $25.0 million in the event that cumulative worldwide sales of HETLIOZ^® reach $250.0 million. Additionally, the Company will be obligated to make royalty payments equal to 10% of net sales of HETLIOZ^®. The Company is also obligated under the license agreement to pay BMS a percentage of any sublicense fees, upfront payments and milestone and other payments (excluding royalties) that the Company receives from a third party in connection with any sublicensing arrangement, at a rate which is in the mid-twenties. Under the license agreement with BMS for HETLIOZ^®, the Company is obligated to use commercially reasonable efforts to develop and commercialize HETLIOZ^® and to meet certain milestones in initiating and completing certain clinical work.

Either party may terminate the HETLIOZ^® license agreement under certain circumstances, including a material breach of the agreement by the other. In the event the Company terminates the license, or if BMS terminates the license due to the Company’s breach, all rights licensed and developed by the Company under the license agreement will revert or otherwise be licensed back to BMS on an exclusive basis.

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Fanapt^®. The Company acquired exclusive worldwide rights to patents and patent applications for Fanapt^® in 2004 through a sublicense agreement with Novartis. As a result of the FDA’s approval of the NDA for Fanapt^® in May 2009, the Company met a milestone under the sublicense agreement, which required the Company to make a payment of $12.0 million to Novartis.

In 2009, the Company entered into an amended and restated sublicense agreement with Novartis, which amended and restated the 2004 sublicense agreement. Pursuant to the amended and restated sublicense agreement, the Company received an upfront payment of $200.0 million and is eligible for additional payments totaling up to $265.0 million upon Novartis’ achievement of certain commercial and development milestones for Fanapt^® in the U.S. and Canada. Based on the current sales performance of Fanapt^® in the U.S., the Company expects that some or all of these commercial and development milestones will not be achieved by Novartis. The Company also receives royalties, which, as a percentage of net sales, are in the low double-digits, on net sales of Fanapt^® in the U.S. and Canada.

The Company retains exclusive rights to Fanapt^® outside the U.S. and Canada, and the Company has exclusive rights to use any of Novartis’ data for Fanapt^® for developing and commercializing Fanapt^® outside the U.S. and Canada. Novartis has chosen not to co-commercialize Fanapt^® with the Company in Europe and certain other countries. These include, but are not limited to, the countries in the European Union as well as Switzerland, Norway, Liechtenstein and Iceland. The Company will be obligated to make royalty payments based on the net sales of Fanapt^® to either Novartis or Sanofi S.A depending on the jurisdiction where the sales occurred. At this time, the Company is only obligated to make a royalty payment to Sanofi S.A. The Company has entered into agreements with the following partners for the commercialization of Fanapt^® in the countries set forth below:

In 2012, the Israeli Ministry of Health granted market approval for Fanapt^® for the treatment of schizophrenia. In October 2013, the Mexican Federal Commission for Protection Against Sanitary Risks (COFEPRIS) granted market approval for Fanapt^® for the treatment of schizophrenia.

VLY-686. In 2012, the Company entered into a license agreement with Eli Lilly and Company (Lilly) pursuant to which the Company acquired an exclusive worldwide license under certain patents and patent applications, and other licenses to intellectual property, to develop and commercialize an NK-1R antagonist, VLY-686, for all human indications. The patent describing VLY-686 as a new chemical entity expires in April 2023, except in the U.S., where it expires in June 2024 absent any applicable patent term adjustments.

Pursuant to the license agreement, the Company will be responsible for all development costs, and Lilly is eligible to receive payments based upon achievement of specified development and commercialization milestones as well as tiered-royalties on net sales at percentage rates up to the low double digits. These milestones include $4.0 million for pre-NDA approval milestones and up to $95.0 million for future regulatory approval and sales milestones. The Company is obligated to use its commercially reasonable efforts to develop and commercialize VLY-686.

Either party may terminate the license agreement under certain circumstances, including a material breach of the license agreement by the other. In the event the Company terminates the license agreement, or if Lilly terminates due to the Company’s breach or for certain other reasons set forth in the license agreement, all rights licensed and developed by the Company under the license agreement will revert or otherwise be licensed back to Lilly on an exclusive basis, subject to payment by Lilly to the Company of a royalty on net sales of products that contain VLY-686.

Future milestone payments. No amounts were recorded as liabilities nor were any future contractual obligations relating to the license agreements included in the consolidated financial statements as of September 30, 2014 because the criteria for recording the future milestone payments have not yet been met. These criteria include the successful outcome of future clinical trials, regulatory filings, favorable FDA regulatory approvals, growth in product sales and other factors.

14. Legal Matters

In May 2014, the Company commenced arbitration proceedings with Novartis relating to the license of Fanapt^®. The Company has requested an award of approximately $539.0 million in such proceedings. The Company is vigorously prosecuting its claims in the arbitration as well as defending counterclaims brought by Novartis for approximately $75.0 million, against which the Company believes it has meritorious defenses. The Company does not anticipate that this proceeding will have a material adverse

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effect on its business, results of operations or financial condition. While it is not possible to accurately predict or determine the eventual outcome of this matter, these proceedings are subject to inherent uncertainties and the Company may not prevail. The Company currently anticipates that the arbitration proceeding will be completed in mid to late 2015.

In June 2014, the Company filed suit against Roxane Laboratories, Inc. (Roxane) in the U.S. District Court for the District of Delaware. The suit seeks an adjudication that Roxane has infringed one or more claims of the Company’s U.S. Patent No. 8,586,610 (the Patent) by submitting to the FDA an Abbreviated New Drug Application for generic versions of Fanapt^® oral tablets in 1 mg, 2 mg, 4 mg, 6 mg, 8 mg, 10 mg, and 12 mg strengths. The relief requested by the Company includes a request for a permanent injunction preventing Roxane from infringing the asserted claims of the Patent by engaging in the manufacture, use, offer to sell, sale, importation or distribution of generic versions of Fanapt^® before the expiration of the Patent in 2027.

15. Employee Stock-Based Compensation

Compensation costs for all stock-based awards to employees and directors are measured based on the grant date fair value of those awards and recognized over the period during which the employee or director is required to perform service in exchange for the award. The Company generally recognizes the expense over the award’s vesting period.

In January 2014, the Company elected to change its method of accounting for the attribution of compensation cost for stock options with graded-vesting and only service conditions from the accelerated attribution method to the straight-line method. See Note 3, Change in Method of Accounting for Stock-based Compensation for additional discussion. The fair value of stock options granted and RSUs awarded are amortized using the straight-line method. As stock-based compensation expense recognized in the consolidated statements of operations is based on awards ultimately expected to vest, it has been reduced for estimated forfeitures. Forfeitures are required to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates.

The fair value of each option award is estimated on the date of grant using the Black-Scholes-Merton option pricing model that uses the assumptions noted in the following table. Expected volatility rates are based on the historical volatility of the Company’s publicly traded common stock and other factors. Beginning in 2014, the Company started using a mid-point scenario to calculate the weighted average expected term of stock options granted, which combines the Company’s historical exercise data with hypothetical exercise data for unexercised stock options. Prior to 2014, the expected term assumption was determined using the simplified method. The risk-free interest rates are based on the U.S. Treasury yield for a period consistent with the expected term of the option in effect at the time of the grant. The Company has not paid dividends to its stockholders since its inception (other than a dividend of preferred share purchase rights, which was declared in September 2008) and does not plan to pay dividends in the foreseeable future.

Assumptions used in the Black-Scholes-Merton option pricing model for employee and director stock options granted during the nine months ended September 30, 2014 and 2013 were as follows:

Total employee stock-based compensation expense related to stock-based awards for the three and nine months ended September 30, 2014 and 2013 was comprised of the following:

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As of September 30, 2014, the Company had two equity incentive plans, the Second Amended and Restated Management Equity Plan (the 2004 Plan) and the 2006 Equity Incentive Plan (the 2006 Plan). There were 652,810 shares subject to outstanding options granted under the 2004 Plan as of September 30, 2014, and no additional options will be granted under this plan. As of September 30, 2014, there were 10,329,472 shares of common stock reserved for issuance under the 2006 Plan, of which 5,854,567 shares were subject to outstanding options and RSUs granted to employees and non-employees and 2,381,075 shares remained available for future grant.

The Company has granted option awards with service conditions that are subject to terms and conditions established by the compensation committee of the board of directors. Service option awards have 10-year contractual terms and all service option awards granted prior to 2007, service option awards granted to new employees, and certain service option awards granted to existing employees vest and become exercisable on the first anniversary of the grant date with respect to the 25% of the shares subject to service option awards. The remaining 75% of the shares subject to the service option awards vest and become exercisable monthly in equal installments thereafter over three years. Certain service option awards granted to existing employees after December 2006 vest and become exercisable monthly in equal installments over four years. The initial service option awards granted to directors upon their election vest and become exercisable in equal monthly installments over a period of four years, while the subsequent annual service option awards granted to directors vest and become exercisable in equal monthly installments over a period of one year. Certain service option awards to executives and directors provide for accelerated vesting if there is a change in control of the Company. Certain service option awards to employees and executives provide for accelerated vesting if the respective employee’s or executive’s service is terminated by the Company for any reason other than cause or permanent disability. As of September 30, 2014, there was $7.7 million of unrecognized compensation costs related to unvested service option awards expected to be recognized over a weighted average period of 1.5 years. No service option awards are classified as a liability as of September 30, 2014.

A summary of option activity for the 2004 Plan for the nine months ended September 30, 2014 follows:

There are no options expected to vest as of September 30, 2014 under the 2004 Plan, given that the Company stopped issuing options from this plan in 2006.

A summary of option activity for the 2006 Plan for the nine months ended September 30, 2014 follows:

Proceeds from the exercise of stock options amounted to $2.7 million for the nine months ended September 30, 2014.

An RSU is a stock award that entitles the holder to receive shares of the Company’s common stock as the award vests. The fair value of each RSU is based on the closing price of the Company’s stock on the date of grant. The Company has granted RSUs with service conditions that vest in four equal annual installments provided that the employee remains employed with the Company. As of September 30, 2014, there was $4.4 million of unrecognized compensation costs related to unvested RSUs expected to be recognized over a weighted average period of 1.9 years. No RSUs are classified as a liability as of September 30, 2014.

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A summary of RSU activity for the 2006 Plan for the nine months ended September 30, 2014 follows:

The grant date fair value for the 209,562 shares underlying RSUs that vested during the nine months ended September 30, 2014 was $1.4 million. In order for certain employees to satisfy the minimum statutory employee tax withholding requirements related to the issuance of common stock underlying certain of the RSUs that vested and settled during the nine months ended September 30, 2014, the Company withheld 32,386 shares of common stock and paid employee payroll withholding taxes of $0.4 million relating to the vesting and settlement of the RSUs.

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ITEM 2 Management’s Discussion and Analysis of Financial Condition and Results of Operations

CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS

Various statements throughout this report are “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. Forward-looking statements may appear throughout this report. Words such as, but not limited to, “believe,” “expect,” “anticipate,” “estimate,” “intend,” “plan,” “project,” “target,” “goal,” “likely,” “will,” “would,” and “could,” or the negative of these terms and similar expressions or words, identify forward-looking statements. Forward-looking statements are based upon current expectations that involve risks, changes in circumstances, assumptions and uncertainties. Important factors that could cause actual results to differ materially from those reflected in our forward-looking statements include, among others: